Paper instructions:Follow the instractions on file, and answer the questions that ask on the file. However, there are 2 files the 1st file is the questions that you need to answer and the 2nd file is helpful for you toanswer the questions.The class is FinanceChapter FourThe Federal Reserve System, MonetaryPolicy and Interest RatesI. Chapter Outline1. Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview2. Structure of the Federal Reserve Systema. Organization of the Federal Reserve Systemb. Board of Governors of the Federal Reserve Systemc. Federal Open Market Committeed. Balance Sheet of the Federal Reservee. Functions Performed by Federal Reserve Banks3. Monetary Policy Toolsa. Open Market Operationsb. The Discount Ratec. Reserve Requirements ( Reserve Ratios)d. The Fed?s Response to the September 11, 2001 Terrorist Attack4. The Federal Reserve, the Money Supply, and Interest Ratesa. Effects of Monetary Tools on Various Economic Variablesb. Money Supply versus Interest Rate Targeting5. International Monetary Policies and Strategiesa. Impact of U.S. Monetary Policy on Foreign Exchange Ratesb. Challenges of Other Major Central BanksII. Chapter in PerspectiveThis chapter presents an overview of the Federal Reserve System, including a brief look at its history and structure. The major functions performed by the Fed are covered and the balance sheetof the Fed is examined. Beyond familiarity with the Fed, the main purpose of the chapter is to provide the reader with a non-technical explanation of the effects of monetary policy on interestrates and the economy. The deposit growth multiplier concept is introduced and a simple ?transmission mechanism? depicting the effects of a change in Fed policy on the economy is presented.Different monetary targets such as borrowed and non-borrowed reserves and interest rate targets are also discussed. Intervention into foreign exchange markets is also briefly covered.III. Key Concepts and Definitions to Communicate to StudentsDiscount rate FRB NY Trading DeskDiscount window Policy directiveCheck clearing Repurchase agreementACH and Fed Wire Primary creditFederal Open Market Committee Seasonal creditOpen market operations Secondary creditReserves Deposit growth multiplierMonetary base M1, M2 and M3Required and excess reserves Foreign exchange interventionFed funds rate Borrowed and non-borrowed reserve targetsTransmission mechanismPolicies of other major central banksIV. Teaching Notes1. Major Duties and Responsibilities of the Federal Reserve System: Chapter OverviewThe Federal Reserve was created in 1913 in response to a series of U.S. financial panics which culminated in a particularly severe panic in 1907. The Fed was created to serve as a lender of lastresort, as a bank regulator and as a monitor of the money supply. Current objectives of the Fed include stimulating sustainable non-inflationary economic growth, keeping employment high andinterest rates low to encourage long term growth. The Fed also assists in facilitating the nation?s payment mechanisms. The Fed operates the Fed Wire which facilitates trading of bank reservesand the Automated Clearing House (ACH), which is a similar payments mechanism for debit and credit transactions. The Fed is largely independent of Congress and the President, at least in theshort run. The Humphrey-Hawkins Act of 1978 however requires the Fed to present their monetary policy goals and an assessment of how well they are meeting their goals to Congress twice ayear.The four major functions of the Fed today include: a) conducting monetary policy, b) supervising and regulating depository institutions, 3) maintaining the stability of the financial system and 4)providing payment and other financial services to many institutions, including governments.2. Structure of the Federal Reserve Systema. Organization of the Federal Reserve SystemThere are 12 Federal Reserve Banks (FRBs) located throughout the country. The structure was originally intended to disperse power along regional lines throughout the country. To some extentthis dispersion still remains but the major authority to promulgate and implement monetary policy now lies in Washington, D.C. with the Board. Each FRB has a nine member Board of Directorsconsisting as follows:? Six are elected by member banks in the district, of these six, three are non-bank business people.? Three are appointed by the Board of Governors of the Federal Reserve System.FRBs are nonprofit organizations, but they are owned by the member banks in their district. Part of the independence of the Fed arises because the Fed generates positive net income frominterest and fees so it is not directly dependent on Congressional funding. As of this writing Fed Chairman Bernanke has submitted a proposal to Congress where the Fed would pay interest onbank reserves. If accepted, this would reduce the profitability of the Fed. If the interest rate paid increases with the Fed funds rate this could also create a perverse incentive that couldconceivably affect Fed policy because Fed profitability would be reduced if the Fed increased interest rate targets. The Fed argues that paying interest would minimize reserve volatility.b. Board of Governors of the Federal Reserve System (BoGov)The BoGov is comprised of seven members and each member is appointed to a non-renewable 14 year term by the President of the United States and confirmed by the Senate. Terms arestaggered so that one term expires every other January. The President appoints the chairman and vice-chairman of the board from among BoGov members to four year terms that can berepeated. The board has two major areas of responsibility; the formulation and conduct of monetary policy through the FOMC (see below), and the promulgation of bank regulations. The boardcan change the discount rate and bank reserve requirements.c. Federal Open Market Committee (FOMC)The 12 member FOMC is the body that formulates and conducts monetary policy. Seven of the 12 members are comprised by the BoGov; thus, the BoGov has a controlling vote on the FOMC.The remaining members are 1) the President of the New York Federal Reserve Bank and 2) four presidents of other Federal Reserve Banks, chosen on a rotating basis. The FOMC conducts openmarket operations to implement monetary policy. Open market operations are the purchase and sale of U.S. government securities to increase or decrease the level of bank reserves (moneysupply) respectively. Open market operations are the most commonly used policy tool to conduct monetary policy. The results of each FOMC meeting are compiled in the so called ?BeigeBook,? which summarizes information on current economic conditions compiled by the district banks, and from interviews with business leaders and economists, etc.d. Functions Performed by Federal Reserve Banks:Functions include:? Assisting in the conduct of monetary policy and economic analysis? Supervision and regulation of banks and bank holding companies in their district? Provision of government services for the U.S. Treasury? Replacement of old currency and issuance of new currency? Providing check clearing services for a fee? The number of checks cleared peaked at 17 billion in 2000 and has since declined as alternatives to checks have risen and industry consolidations. As of October 2004 the Check 21 Actauthorizes the use of an electronic image rather than a paper check for settlement. This switch is projected to save the banking industry as much as $3 billion per year. Presumably competitionwill force banks to pass on the cost savings to customers in the form of reduced checking fees. Customers will lose the ability to play the float (which can be several days) as checks can now bevery quickly cleared (as soon as deposited), making them more similar to most debit cards. Customers will have to take care that sufficient funds are available at the time the check is spentwith most retailers or they could overdraw. For instance a customer could no longer write a check in the afternoon the day before payday, knowing that the check will not clear before thepayroll deposit the next day. This is a dubious practice anyway (technically it is kiting, an illegal activity). However, in our region, banks are not as of this writing (2008) aggressivelyattempting to reduce customer usage of float. Nevertheless, customers who run low balances would be advised to apply for overdraft protection.? Providing wire transfer services through the Fed Wire? Providing district economic analysis and research? According to the Financial Services Policy Committee of the Federal Reserve, in 2006 more than 2/3 of noncash payments were electronic. The breakdown was as follows:? 30 billion checks processed ($42 trillion)? 63 billion electronic payments ($34 trillion)? 25 billion debit? 22 billion credit? 15 billion ACH (much larger transaction size than debit or credit categories)e. Balance Sheet of the Federal ReserveMajor liabilities include (2007):Money (Monetary) Base: Currency in circulation (84.7%) plus Reserves (2.0%)Reserves are DI reserve balances (required and excess) at the FedVault cash (4.6%)FRB stock (1.8%)Major assets include (2007):U.S. Treasury securities (86.5%)Security Repurchase Agreements (3.7%)Treasury currency (4.2%)Gold and foreign exchange (3.5%)3. Monetary Policy ToolsThe major process by which the Fed impacts the economy is through influencing the market for bank reserves. Banks trade excess reserves among themselves at the interest rate called the fedfunds rate. The Fed attempts to influence the fed funds rate by either affecting demand or supply of funds available for lending between banks. Targeting the level of reserves in the economy istantamount to targeting the supply of funds available for bank to bank lending (and by inference, the amount of funds available for lending to non-bank customers). Targeting interest rates, asthe Fed has done since 1993, is the same as influencing the demand for bank reserves. The Fed cut interest rates 11 times in 2001 to stimulate the weakening economy. The fed funds target ratewas increased 5 times in 2004 from a low of 1% to a year ending high of 2.5% (each increase was 25 basis points). In June 2005 the target fed funds rate was 3.25% but by August 2006 the targetrate had been increased to 5.25% due to inflation fears. In 2007 the Fed reversed its interest rate policy and began to decrease the Fed funds target. As of April 30, 2008 the Fed funds target was2.00% and the discount rate was 2.25%. The Fed has also expanded availability of Discount Window borrowing to investment banks in order to encourage liquidity in the financial system.Liquidity had been impaired by the credit crunch spurred by the fallout in the subprime mortgage markets. The Fed and the Treasury helped arrange a bailout of Bear Stearns by J.P. MorganChase. Bear Stearns was a failing investment bank heavily involved in the mortgage markets and was on the brink of defaulting on many of its repo arrangements. The Fed took theunprecedented step of guaranteeing $30 billion of Bear Stearn?s illiquid mortgage assets. Even before the bailout of Bear Stearns the Fed had agreed to swap up to $200 billion of Treasuries itholds for illiquid mortgage backed securities in an effort to restore liquidity to the markets. In particular the short term repo markets had stopped functioning on worries about failures ofunderlying mortgages backing securities, many through CDO structures.The worst of the credit crunch appears to be over as of this writing and banks are able to raise new capital, although I suspect that bank profitability will remain poor throughout much of 2008.The Fed also announces an estimate of the primary risk in the economy, recession, inflation or deflation or a balance among the risks. In May 2008, the Fed estimated that while the economy isstill weak, and it expected inflation to moderate, inflation risks remain high. Non core inflation has been about 4% recently, too high by Fed standards. The rapid decline in U.S. interest rates inlate 2007 and 2008 also precipitated a drop in the U.S. dollar which further spurred commodity prices and inflation.Current rates & risks over the year, with links to meeting minutes can quickly be found at the Federal Reserve Monitor of the Wall Street Journal Online website. Levels of M1 and M2 can be foundon the same website under Federal Reserve Data.a. Open Market OperationsOpen market operations are the buying and selling of U.S. government securities by the Fed. The FOMC drafts a policy directive to change a targeted monetary aggregate such as M1, M2, M3 oran interest rate target such as the fed funds rate and sends it to the N.Y. Federal Reserve Bank Trading Desk. If the FOMC wishes to increase the money supply the directive will specify that theTrading Desk is to buy U.S. government securities and credit the seller with additional reserves at the Fed. In this manner new money is created. If the FOMC wishes to decrease the moneysupply, securities will be sold and the buyer will pay for them by having bank reserves removed from their account. Temporary changes in the money supply can be enacted by using repurchaseagreements. Fed use of a repo will temporarily increase the money supply; a reverse repo could be used to temporarily reduce bank reserves and the money supply.Teaching Tip: Many students think that the primary method of increasing the money supply is by printing new money. In actuality, increases in the money supply are usually accomplished byincreasing bank reserves.Teaching Tip: The U.S. Treasury operates the mints for coins.Teaching Tip: Part of the importance of the target fed funds rate is that this rate affects other rates because this interest rate reflects the bank?s cost of short term funds. In particular, theprime rate usually changes after a change in the fed funds rate.b. The Discount RateHistorically, the discount rate is the rate the Federal Reserve Banks charge to make emergency loans to DIs in fulfilling its role as lender of last resort. The Fed implemented changes in itsdiscount window policy in January 2003. The changes did two things, 1) raise the cost of borrowing from the Fed and 2) make it easier for banks to borrow from the Fed. There are now threelending programs available from the discount window:1. Primary credit ? Primary credit is available to healthy depository institutions (DIs) on a short term basis. The borrowed funds are not restricted in their use. The rate paid is typically1% above the fed funds target rate. As of June 2005, the discount rate was 4.25%. Traditionally the discount rate was kept below the fed funds rate, but banks were limited to borrowing fromthe Fed only if they could show they could not borrow from the private markets (such as the fed funds market).2. Secondary credit ? Short term secondary credit is available to troubled institutions. The interest rate charged is higher than the rate on primary credit. Secondary credit is restrictedin how the funds may be used. The borrowing bank cannot use secondary credit to expand the bank?s assets.3. Seasonal credit ? Seasonal credit is available for institutions that can demonstrate a pattern of intra-year changes in borrowing needs, usually due to seasonal deposit changes and loandemand as occurs in agricultural or tourist dependent areas. Seasonal credit is available on a longer term basis and allows the borrowing institution to carry less liquid assets which are lowearning to meet funds needs.The discount rate is not a direct monetary policy tool and it would be very difficult to predict the change in borrowing that would result from a change in the discount rate. Changes in thediscount rate have at times however signaled the Fed?s intentions to allow interest rates to move in one direction or the other. As mentioned earlier, the Fed has now opened up the discountwindow to securities brokers and dealers and has decreased the spread between the Fed funds target rate and the Discount Rate to 25 basis points.c. Reserve Requirements (Reserve Ratios)The third, and least used, monetary policy tool is changes to the reserve requirement ratios. Banks are required to maintain reserves on deposit at the Fed to back a certain percentage(basically 10%) of transaction deposits. If this ratio is increased, or if it is imposed on more types of accounts, banks will have to hold more reserves at the Fed and less money will be availableto flow through the economy. The change in bank deposits is (1 / New reserve requirement) ? New excess reserves, assuming no drains.If reserves are $2 billion and the Fed increases reserves by 1% or $20 million when banks have a 10% reserve requirement then the predicted increase in bank deposits would equal:1/0.10 * $20 million = $200 million increase in bank deposits.If the Fed reduced the reserve requirement to 9% instead then the new level of excess reserves would be 1% of $2 billion or $20 million. The predicted increase in bank deposits would then equal:1/0.09 * $20 million = $222 millionThe amount of drains is not very predictable. For instance, decreases in reserve requirements cannot be guaranteed to lead to increases in the money available for lending if banks choose tohold higher amounts of excess reserves at the Fed (as they did in the early 1990s and again in 2008.) Changes in the reserve requirement are rarely used as a monetary policy tool. This isperhaps because it is difficult to predict the effect of changes in the reserve ratio on the money supply. Changing the ratio frequently would likely impose additional costs on the bankingsystem which attempts to manage and minimize its excess reserves.d. The Fed?s Response to the September 11, 2001 Terrorist AttackThe major response of the Fed to the September 11, 2001 terrorist attacks was to provide additional liquidity to the financial system. Deposits at Federal Reserve Banks were increased fivefoldby September 12.The Fed (or the Comptroller of the Currency):1. Increased the money supply by entering into or extending existing repurchase agreements2. Lent extensively through the discount window ($45 billion instead of the typical $59 million)3. The Comptroller of the Currency asked banks to extend any loans suffering from short term liquidity problems4. Extended the time period for clearing checks (needed since the planes that carried checks were grounded).5. Arranged to swap currencies as needed with foreign central banks to ensure that payments to be made in foreign currencies could be paid on time and to ensure that foreignsubsidiaries of U.S. firms could obtain dollars quickly if needed.6. Reduced the Fed funds target by 50 basis points to 3%.The resulting increase in liquidity helped quickly stabilize the U.S. financial markets in the aftermath of the attacks. Notice that in this instance the discount window served a very importantpurpose in quickly providing liquidity during the crisis.4. The Federal Reserve, the Money Supply, and Interest Ratesa. Effects of Monetary Tools on Various Economic VariablesIf the Fed wishes to increase the money supply it can? Buy U.S. Government Securities? Decrease the Discount Rate? Lower reserve requirementsAll three result in lower interest rates which encourage additional borrowing for consumption and investment. As household and business spending increase, the total value of goods andservices produced in the economy (nominal Gross Domestic Product or GDP) increases. Employment should increase as a result. The converse holds for opposite movements in the variables.Teaching Tip: Lower interest rates normally lead to increases in nominal GDP. Nominal GDP = ? (Price ? Quantity) for all goods and services produced in the economy. Either Price (inflation) orQuantity (real output), or both, will rise, albeit with lags. If the economy is not at full capacity, or if productivity is growing so that capacity is growing, the increase in nominal GDP will occurprimarily through an increase in the quantity of goods and services produced, at least in the short run. If the economy is near capacity the GDP growth is liable to occur through price increases(inflation). Moreover, if economic participants have expectations of inflation, then prices are likely to rise.Teaching Tip: Inflation is a fairly recent phenomenon and probably results from fiat money. If one takes a historical perspective there is no reason to expect constant positive inflation and noreason to fear deflation. It is entirely possible that during the 1990s the Fed allowed overly rapid monetary growth under the mistaken belief that disinflation would be undesirable. Centralbankers tend to fear Keyne?s liquidity trap: during deflation, high real rates can occur and the Fed may then be unable to lower nominal interest rates enough to stimulate the economy.Something very similar to this recently occurred in Japan. In those cases fiscal policy is needed to stimulate economic growth. It is quite plausible that with the recent large productivity gainsin the U.S. during the 1990s, prices should actually have fallen without the stimulative monetary policy at that time.Teaching Tip: Until recently the U.S. had enjoyed mild real asset inflation overall for quite some time, but financial asset inflation was prevalent throughout the 1990s in the stock market andselected real asset markets such as real estate have experienced inflation in certain segments of the economy. An interesting question is whether the Fed should have responded sooner to thefinancial asset inflation. Historically, long inflationary cycles tend to be followed by long periods of poor growth. We will have to see if the U.S. real estate sector will experience a long slump inhousing prices. Experience in Japan (and historically in the U.S.) indicates that if a cycle of deflation occurs in the real estate sector the U.S. economy may slump and that slump may well indeedbe protracted. Currently, with oil prices over $125 a barrel, inflation in food and energy prices up sharply, the Fed may be faced with difficult policy choices at a time when even with lowinterest rates the economic activity remains weak and inflationary pressures remain high.Money Supply versus Interest Rate TargetingThe Fed can target either some monetary aggregate (M1 or M2 for example) or interest rates, but not both simultaneously. During the 1970s, Arthur Burns and other Fed chairmen targetedinterest rates. During the 1970s the United States experienced rapid inflation, due in part to the oil embargoes. During this time period the Fed overstimulated the economy by trying tomaintain a target fed funds rate. Recall that the Fisher effect states that nominal rates will rise due to expected inflation. The Fed continually increased the money supply to offset the pressurehigh expected inflation was exerting on interest rates. However, inflation is caused by excess demand (too much money available relative to the goods and services produced). By keepinginterest rates low the Fed actually fueled excess demand for borrowing. Paul Volcker became chairman of the Fed in 1979 and he changed the Fed?s target from interest rates to non-borrowedreserves and managed to purge inflation from the economy. Due to increases in volatility of M1 and growing instability of velocity (the relationship between money and economic activity), theFed had trouble hitting money supply targets. In 1993 the Fed announced it would once again target interest rates and began publicly announcing the desired fed funds rate for the first time.Teaching Tip:The instructor should emphasize that an interest rate target as practiced in the 1970s will not work in an environment with rapid inflation. If we return to an inflationary environment, the Fedwill have to be willing to significantly raise the fed funds rate to reduce inflation.Teaching Tip:The difference between M1, M2 and M3 is liquidity. Recall Keynes? functional definition of money as any asset that serves as a medium of exchange, a store of value and a unit of account.Accounts in M1 are clearly mediums of exchange and the additional accounts in M2 and M3, while less liquid than those in M1, meet the store of value function of money.Money Supply measuresJanuary 2008 Billions $ % of Total money supply as measured by M2M1 $1,363 18%M2 (includes M1) $7,456In September 2007 about 18% of the M2 money supply was held in the highly liquid accounts, and the remainder in either less liquid accounts.Teaching Tip:Bernanke, the current Chairman of the Federal Reserve, has broken with Greenspan?s policy of only gradually changing interest rates in small increments, usually 25 basis points. This policy gaveinvestors time to adjust to changing interest rates.Teaching Tip:Some economists believe that the Federal Reserve should announce a target inflation rate and limit monetary policy changes to hitting this target. Others believe the Fed should employ adifferent type of monetary policy rule where the rate of money supply growth is tied inflexibly to the economic growth rate. Most economists however believe that there are enough shocks tothe system that require more intervention by the Federal Reserve than a rule or inflexible target would allow.Teaching Tip:Was Greenspan a genius ? or just lucky?Greenspan was fortunate to be Fed Chairman during a very long period of global growth (albeit with some significant bumps along the way). During his tenure global growth was quite high onaverage and 1990s U.S. productivity growth was extremely high. Throughout much of his tenure inflation was benign and he was able to allow long periods of rapid U.S. monetary growth withoutgenerating inflation (annual money supply growth rates have generally been much greater than our economic growth rates). This strategy succeeded in large part because of foreigners? ongoingwillingness to acquire dollars and dollar denominated assets. Earlier in his tenure, foreign private agents were acquiring dollars, but in recent years a greater proportion of acquisitions ofdollars have been made by foreign central banks attempting to keep their currency from appreciating. To the extent that they have succeeded, their actions have probably hurt U.S. firmscompeting with foreign imports. His low rate policies also allowed U.S. economic agents, such as the government, households and firms, to rack up record high debt levels without generatingpressure on interest rates to rise. Until recently, the repercussions did not seem significant. The recent decline in the dollar coupled with higher digit inflation and weaker growth may proveotherwise. Was he smart or just lucky?International Monetary Policies and Strategiesb. Impact of U.S. Monetary Policy on Foreign Exchange RatesThe Fed can affect the exchange value of the dollar by buying and selling foreign currencies against the dollar (foreign exchange intervention). The U.S. practices a managed float and attemptsto influence the value of the dollar in concert with other central banks. The Fed faces a tradeoff in maintaining a stable currency value and low U.S. inflation. If the U.S. has lower inflation thanother countries, the value of the U.S. dollar will tend to appreciate, ceteris paribus. An appreciating dollar can hurt U.S. exports and worsen our trade deficit. Conversely, a falling dollar cangenerate U.S. inflation by putting pressure on foreign firms (exporters to the U.S.) to raise U.S. prices to preserve their local currency value of their revenues. The Fed has difficulty maintainingthe value of the dollar and managing U.S. inflation simultaneously. Suppose inflation is just where the Fed wants it, but the dollar is falling against the yen because Japan is running lowerinflation than the U.S. If the U.S. wishes to stop the dollar from falling, the Fed could theoretically sell $1 billion worth of yen denominated assets to commercial bank currency traders fordollars. The Fed would receive payment from the commercial bank purchasers by debiting the commercial banks? reserves at the Fed by $1 billion. This would decrease the U.S. money supply andshould then result in a decrease in U.S. inflation. Consequently, cooperation between central banks is needed to work out the tradeoffs between domestic inflation and currency values aroundthe world.Teaching Tip:Because currency intervention normally requires foreign currency reserves, the levels of these reserves in developing countries that may experience a currency devaluation are closely watchedby currency speculators. The Economist publishes foreign currency reserves for most developing countries.c. Challenges of Other Major Central Banks? Bank of Japan (BOJ): The BOJ has perhaps weathered the toughest challenge of any central bank leading a major economy although the Fed may soon face a similarly severe test. Japanhas arguably had three severe recessions in the past decade or so. Nominal interest rates were pushed down to essentially zero, the government pursued very expansionary fiscal policies, butbusiness investment remained weak. In March 2001 the BOJ switched from targeting interest rates to targeting a measure of bank reserves and began increasing the money supply. Japanesecommercial banks have traditionally engaged in loans collateralized by real estate and prior to the Basel Accord, the banks could count their own real estate holdings as equity capital. Thecollapse of the real estate markets in the 1990s led to weak collateral on extensive amounts of bad loans. The government tried to prop up the politically sensitive construction industry, buttoo little avail. In September 2002 the BOJ proposed to purchase a portion of the equity of problem banks in order to give these banks cash and improve their equity values.Teaching Tip:Due to deflation, real rates were higher than nominal rates, and at times long term real rates may have hit highs of 5%-6%, too high to stimulate growth. Nevertheless, this doesn?texplain why the expansionary fiscal policy has been unable to generate sustainable growth. To understand this failure, one has to look deeper into Japanese business practices. The shortanswer is that Japan?s business cartels and the heavy government protection and involvement in businesses resulted in anticompetitive business practices. Refusing to outsource and globalizethe Japanese economy led to a decade long malaise. Fortunately, this has and is changing. Opening the economy to foreign investment in both the financial and nonfinancial sectors has helpedto improve the Japanese economy.Japan?s economy is now performing better, but it still suffers from weak internal business investment demand. Nevertheless, perhaps the greatest problem facing the Japanese is the rapid agingof their society (much more rapid than the U.S.). Aging will put tremendous pressure on their social systems while slowing their capacity to generate growth.? European Central Bank (ECB): The challenges facing the ECB are quite different. The ECB has been heavily criticized for following an opaque policy, targeting the money supply (M3)rather than announcing a target Fed funds rate as the U.S. Federal Reserve does or a target inflation rate as the Bank of England. The ECB chose a money supply target because the data for thisvariable is more reliable than for many other economic indicators which are calculated in different ways in some of the different countries they manage. Due to political pressure the ECB nowannounces an inflation rate target (as of 2003). The ECB has faced a difficult challenge because they have had to learn how to manage a group of quite diverse economies, ranging from industrialpowerhouses like Germany and France, to lesser developed economies such as Spain, Portugal and Greece, and now some even weaker economies. In May of 2004, the EU was expanded to includeCyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. Economic theory tells us that common curren
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