MODULE 31: Monetary Policy and the Interest Rate

Monetary Policy and the Interest Rate

AP® Exam Tip

Don’t confuse the federal funds rate with the discount rate. The Fed can only target the federal funds rate because it is set through the interaction of supply and demand.

Let’s examine how the Federal Reserve can use changes in the money supply to change the interest rate. Figure 31.1 shows what happens when the Fed increases the money supply from to . The economy is originally in equilibrium at E₁, with the equilibrium interest rate r₁ and the money supply . When the Fed increases the money supply to , the money supply curve shifts to the right, from MS₁ to MS₂, and the equilibrium interest rate falls to r₂. Why? Because r₂ is the only interest rate at which the public is willing to hold the quantity of money actually supplied, . So an increase in the money supply drives the interest rate down. Similarly, a reduction in the money supply drives the interest rate up. By adjusting the money supply up or down, the Fed can set the interest rate.

Figure 31.1: The Effect of an Increase in the Money Supply on the Interest RateThe Federal Reserve can lower the interest rate by increasing the money supply. Here, the equilibrium interest rate falls from r₁ to r₂ in response to an increase in the money supply from

. In order to induce people to hold the larger quantity of money, the interest rate must fall from r₁ to r₂.

The Federal Reserve can move the interest rate through open-market operations that shift the money supply curve. In practice, the Fed sets a target federal funds rate and uses open-market operations to achieve that target.

In practice, at each meeting the Federal Open Market Committee decides on the interest rate to prevail for the next six weeks, until its next meeting. The Fed sets a target federal funds rate, a desired level for the federal funds rate. This target is then enforced by the Open Market Desk of the Federal Reserve Bank of New York, which adjusts the money supply through open-market operations—the purchase or sale of Treasury bills—until the actual federal funds rate equals the target rate. The other tools of monetary policy, lending through the discount window and changes in reserve requirements, aren’t used on a regular basis (although the Fed used discount window lending in its efforts to address the 2008 financial crisis).

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Figure 31.2 shows how interest rate targeting works. In both panels, r_T is the target federal funds rate. In panel (a), the initial money supply curve is MS₁ with money supply , and the equilibrium interest rate, r₁, is above the target rate. To lower the interest rate to r_T , the Fed makes an open-market purchase of Treasury bills, which leads to an increase in the money supply via the money multiplier. This is illustrated in panel (a) by the rightward shift of the money supply curve from MS₁ to MS₂ and an increase in the money supply to . This drives the equilibrium interest rate down to the target rate, r_T.

Figure 31.2: Setting the Federal Funds RateThe Federal Reserve sets a target for the federal funds rate and uses open-market operations to achieve that target. In both panels the target rate is r_T. In panel (a) the initial equilibrium interest rate, r₁, is above the target rate. The Fed increases the money supply by making an open-market purchase of Treasury bills, pushing the money supply curve rightward, from MS₁ to MS₂, and driving the interest rate down to r_T. In panel (b) the initial equilibrium interest rate, r₁, is below the target rate. The Fed reduces the money supply by making an open-market sale of Treasury bills, pushing the money supply curve leftward, from MS₁ to MS₂, and driving the interest rate up to r_T.

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The Fed Reverses Course

During the summer of 2007, many called for a change in Federal Reserve policy. At first the Fed remained unmoved. On August 7, 2007, the Federal Open Market Committee decided to make no change in its interest rate policy. The official statement, however, did concede that “financial markets have been volatile in recent weeks” and that “credit conditions have become tighter for some households and businesses.”

Just three days later, the Fed issued a special statement basically assuring market players that it was paying attention; on August 17 it issued another statement declaring that it was “monitoring the situation,” which is Fed-speak for “we’re getting nervous.” And on September 18, the Fed did what CNBC analyst Jim Cramer wanted: it cut the target federal funds rate “to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.” In effect, it conceded that Cramer’s worries were at least partly right.

It was the beginning of a major change in monetary policy. The figure below shows two interest rates from the beginning of 2004 to 2013: the target federal funds rate decided by the Federal Open Market Committee, which dropped in a series of steps starting in September 2007, and the average effective rate that prevailed in the market each day. The figure shows that the interest rate cut six weeks after Cramer’s diatribe was only the first of several cuts. As you can see, this was a reversal of previous policy: previously the Fed had generally been raising rates, not reducing them, out of concern that inflation might become a problem. But starting in September 2007, fighting the financial crisis took priority. By the way, notice how beginning late in 2008, it looks as if there are two target federal funds rates. What happened? The Federal Open Market Committee set a target range for the federal funds rate, between 0% and 0.25%. That target range was still in effect at the time of writing in 2014.

Source: Federal Reserve Bank of St. Louis.

The figure also shows that the Fed doesn’t always hit its target. There were a number of days, especially in 2008, when the actual federal funds rate was significantly above or below the target rate. But these episodes didn’t last long, and overall the Fed got what it wanted, at least as far as short-term interest rates were concerned.

Panel (b) shows the opposite case. Again, the initial money supply curve is MS₁ with money supply . But this time the equilibrium interest rate, r₁, is below the target federal funds rate, r_T. In this case, the Fed will make an open-market sale of Treasury bills, leading to a fall in the money supply to via the money multiplier. The money supply curve shifts leftward from MS₁ to MS₂, driving the equilibrium interest rate up to the target federal funds rate, r_T.