Classroom Activity: Interest Rates and the Federal Reserve

By the end of this activity students should:
1. Be comfortable with and be able to use nominal interest rates and inflation rates to compute a real interest rate (or real interest rates and inflation rates to compute a nominal interest rate);
2. Understand how inflation impacts purchasing power and identify who gains/loses with inflation.
3. Be able to explain how changes in the Fed Funds rate impacts overall borrowing and lending;
4. Recognize the limits of conventional monetary policy, and the need for unconventional policy, at near zero interest rates;
5. Understand the importance of inflation expectations as well as errors in expectations and identify who gains/loses when errors are present;
6. Understand the importance of and interpret Federal Reserve language related to guiding inflation expectations (forward guidance).

This activity can be completed in 50 minutes. Deeper analysis and discussion of the role of forward guidance would necessitate more class time. This activity would work best for classes no larger than 100 students, although it could be implemented in a larger lecture with the assistance of TAs. A deck of playing cards is necessary for each 36 students (18 pairs). In addition, the instructor will need 1 die and a sample market basket of goods and services. This activity would ideally be sequenced after students have been exposed to how open market operations function.

In this classroom activity students work in groups (pairs) that include a borrower (consumer or firm) and a lender (bank). There are three rounds of activity that the pairs engage in. In each round, the borrower takes out a loan with a principle amount of $10,000 and a simple interest rate. In round 1, the interest rate is determined by the value of the playing card the pair is dealt. Students calculate a payback amount. An inflation rate is announced at the end of the period and students determine whether the borrower, or lender, is better off at the end of the period. Discussion questions in this round focus on the role of inflation in transferring purchasing power from one party to another. This round should prepare students for thinking about inflation expectations and how borrowers/lenders might try to hedge against losses by forming inflationary expectations. In round 2, changes in the federal funds rate are announced and students determine the likelihood that the bank will lend to consumers or firms. Discussion questions for this round focus on the relationship between the federal funds rate and overall lending/economic activity. as well as the ineffectiveness of conventional monetary policy when the federal funds rate reaches the zero bound. In round 3, borrowers set a nominal interest rate based on their expected real rate and an expected rate of inflation. An actual rate of inflation is revealed at the end of the period and students determine whether the borrower, or lender, is better off. Discussion questions for this round focus on the roll of the Federal Reserve in providing forward guidance around inflationary expectations.
Student Worksheet (Acrobat (PDF) 277kB Nov6 13)
Student Instructions (Microsoft Word 2007 (.docx) 19kB Nov6 13)
Instructor Script (Microsoft Word 2007 (.docx) 20kB Nov6 13)
Instructor Instructions (Microsoft Word 2007 (.docx) 19kB Nov6 13)
Explanation (Microsoft Word 2007 (.docx) 15kB Nov6 13)

1. Student pairs will turn in a completed student worksheet.
2. Stop, think and discuss questions associated with each round of activity allow students to demonstrate emerging understanding.

Federal Reserve Open Market Committee Press Releases

Historical Federal Funds Rate Data