1.3 Module 74: Monetary Policy and the Interest Rate

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In the previous module we developed a model of the money market to show how the interest rate is determined in the short run. Now we are ready to use this model to explain how the Federal Reserve can use monetary policy to stabilize the economy in the short run.

The Fed, the Money Supply, and the Interest Rate

Let’s examine how the Federal Reserve can use changes in the money supply to change the interest rate. Figure 74-1 shows what happens when the Fed increases the money supply from to .

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

The economy is originally in equilibrium at E₁, with the equilibrium interest rate r₁ and the money supply . An increase in the money supply by the Fed to shifts the money supply curve to the right, from MS₁ to MS₂, and leads to a fall in the equilibrium interest rate 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.

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.

Figure 74-2 shows how the Fed adjusts the money supply in order to change the interest rate and achieve its target federal funds rate. 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. An open-market purchase of Treasury bills 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.

The 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.

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.

Long-Term Interest Rates

In the previous module we mentioned that long-term interest rates—rates on bonds or loans that mature in several years—don’t necessarily move with short-term interest rates. How is that possible, and what does it say about monetary policy?

Consider the case of Millie, who has already decided to place $10,000 in U.S. government bonds for the next two years. However, she hasn’t decided whether to put the money in one-year bonds, at a 4% rate of interest, or two-year bonds, at a 5% rate of interest. If she buys the one-year bond, then in one year, Millie will receive the $10,000 she paid for the bond (the principal) plus interest earned. If instead she buys the two-year bond, Millie will have to wait until the end of the second year to receive her principal and her interest.

Advertising during the two world wars increased the demand for government long-term bonds from savers who may have been reluctant, at other times, to tie up their funds for several years.

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You might think that the two-year bonds are a clearly better deal—but they may not be. Suppose that Millie expects the rate of interest on one-year bonds to rise sharply next year. If she puts her funds in one-year bonds this year, she will be able to reinvest the money at a much higher rate next year. And this could give her a two-year rate of return that is higher than if she put her funds into the two-year bonds today.

For example, if the rate of interest on one-year bonds rises from 4% this year to 8% next year, putting her funds in a one-year bond today and in another one-year bond a year from now will give her an annual rate of return over the next two years of about 6%, better than the 5% rate on two-year bonds.

The same considerations apply to all investors deciding between short-term and long-term bonds. If they expect short-term interest rates to rise, investors may buy short-term bonds even if long-term bonds bought today offer a higher interest rate today. If they expect short-term interest rates to fall, investors may buy long-term bonds even if short-term bonds bought today offer a higher interest rate today.

As this example suggests, long-term interest rates largely reflect the average expectation in the market about what’s going to happen to short-term rates in the future. When long-term rates are higher than short-term rates, the market is signaling that it expects short-term rates to rise in the future.

This is not, however, the whole story: risk is also a factor. Return to the example of Millie, deciding whether to buy one-year or two-year bonds. Suppose that there is some chance she will need to cash in her investment after just one year—say, to meet an emergency medical bill. If she buys two-year bonds, she would have to sell those bonds to meet the unexpected expense. But what price will she get for those bonds? It depends on what has happened to interest rates in the rest of the economy. Recall that bond prices and interest rates move in opposite directions: if interest rates rise, bond prices fall, and vice versa.

This means that Millie will face extra risk if she buys two-year rather than one-year bonds, because if a year from now bond prices fall and she must sell her bonds in order to raise cash, she will lose money on the bonds.

Owing to this risk factor, long-term interest rates are, on average, higher than short-term rates in order to compensate long-term bond purchasers for the higher risk they face (although this relationship is reversed when short-term rates are unusually high).

The fact that long-term rates don’t necessarily move with short-term rates is sometimes an important consideration for monetary policy.

FED REVERSES COURSE

The Fed’s decision in March 2008 to cut its target interest rate represented a dramatic reversal of Fed policy that began in September 2007.

Figure 74-3 shows two interest rates from the beginning of 2004 through 2013: the target federal funds rate, decided by the Federal Open Market Committee, and the effective, or actual, rate in the market.

Source: Federal Reserve Bank of St. Louis.

As you can see, the Fed raised its target rate in a series of steps from late 2004 until the middle of 2006; it did this to head off the possibility of an overheating economy and rising inflation.

But the Fed dramatically reversed course beginning in September 2007, as falling housing prices triggered a growing financial crisis and ultimately a severe recession. And in December 2008, the Fed decided to allow the federal funds rate to move inside a target band between 0% and 0.25%. From 2009 through 2013, the Fed funds rate was kept close to zero in response to a very weak economy and high unemployment.

Figure 74-3 also shows that the Fed doesn’t always hit its target. There were a number of days, especially in 2008, when the effective 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.

Monetary Policy and Aggregate Demand

In an earlier section we saw how fiscal policy can be used to stabilize the economy. Now we will see how monetary policy—changes in the money supply and the interest rate—can play the same role.

Expansionary and Contractionary Monetary Policy

In Module 63 we learned that monetary policy shifts the aggregate demand curve. We can now explain how that works: through the effect of monetary policy on the interest rate.

Figure 74-4 illustrates the process. Suppose, first, that the Federal Reserve wants to reduce interest rates, so it expands the money supply. As you can see in the top portion of the figure, a lower interest rate, in turn, will lead, other things equal, to more investment spending. This will in turn lead to higher consumer spending, through the multiplier process, and to an increase in aggregate output demanded.

The top portion shows what happens when the Fed adopts an expansionary monetary policy and increases the money supply. Interest rates fall, leading to higher investment spending, which raises income, which, in turn, raises consumer spending and shifts the AD curve to the right. The bottom portion shows what happens when the Fed adopts a contractionary monetary policy and reduces the money supply. Interest rates rise, leading to lower investment spending and a reduction in income. This lowers consumer spending and shifts the AD curve to the left.

In the end, the total quantity of goods and services demanded at any given aggregate price level rises when the quantity of money increases, and the AD curve shifts to the right. Monetary policy that increases the demand for goods and services is known as expansionary monetary policy.

Suppose, alternatively, that the Federal Reserve wants to increase interest rates, so it contracts the money supply. You can see this process illustrated in the bottom portion of the diagram. Contraction of the money supply leads to a higher interest rate. The higher interest rate leads to lower investment spending, then to lower consumer spending, and then to a decrease in aggregate output demanded.

© The New Yorker Collection 1997 Robert Mankoff from cartoonbank.com. All Rights Reserved.

So the total quantity of goods and services demanded falls when the money supply is reduced, and the AD curve shifts to the left. Monetary policy that decreases the demand for goods and services is called contractionary monetary policy.

Monetary Policy in Practice

How does the Fed decide whether to use expansionary or contractionary monetary policy? And how does it decide how much is enough? As we know, policy makers try to fight recessions, as well as try to ensure price stability: low (though usually not zero) inflation. Actual monetary policy reflects a combination of these goals.

In general, the Federal Reserve and other central banks tend to engage in expansionary monetary policy when actual real GDP is below potential output. Panel (a) of Figure 74-5 shows the U.S. output gap, which we’ve previously defined as the percentage difference between actual real GDP and potential output, versus the federal funds rate since 1985. (Recall that the output gap is positive when actual real GDP exceeds potential output.) As you can see, the Fed has tended to raise interest rates when the output gap is rising—that is, when the economy is developing an inflationary gap—and cut rates when the output gap is falling.

Panel (a) shows that the federal funds rate usually rises when the output gap is positive—that is, when actual real GDP is above potential output—and falls when the output gap is negative. Panel (b) illustrates that the federal funds rate tends to be high when inflation is high and low when inflation is low.

Sources: Bureau of Labor Statistics; Congressional Budget Office; Federal Reserve Bank of St. Louis.

The big exception was the late 1990s, when the Fed left rates steady for several years even as the economy developed a positive output gap (which went along with a low unemployment rate). One reason the Fed was willing to keep interest rates low in the late 1990s was that inflation was low.

Panel (b) of Figure 74-5 compares the inflation rate, measured as the rate of change in consumer prices excluding food and energy, with the federal funds rate. You can see how low inflation during the mid-1990s, the early 2000s, and the late 2000s helped encourage loose monetary policy in the late 1990s, in 2002–2003, and again beginning in 2008.

The Taylor Rule Method of Setting Monetary Policy

In 1993 Stanford economist John Taylor suggested that monetary policy should follow a simple rule that takes into account concerns about both the business cycle and inflation. He also suggested that actual monetary policy often looks as if the Federal Reserve was, in fact, more or less following the proposed rule. A Taylor rule for monetary policy is a rule for setting interest rates that takes into account the inflation rate and the output gap or, in some cases, the unemployment rate.

A widely cited example of a Taylor rule is a relationship among Fed policy, inflation, and unemployment estimated by economists at the Federal Reserve Bank of San Francisco. These economists found that between 1988 and 2008 the Fed’s behavior was well summarized by the following Taylor rule:

where the inflation rate was measured by the change over the previous year in consumer prices excluding food and energy, and the unemployment gap was the difference between the actual unemployment rate and Congressional Budget Office estimates of the natural rate of unemployment.

Figure 74-6 compares the federal funds rate predicted by this rule with the actual federal funds rate from 1985 to 2012. As you can see, the Fed’s decisions were quite close to those predicted by this particular Taylor rule from 1988 through the end of 2008. We’ll talk about what happened after 2008 shortly.

The red line shows the federal funds rate predicted by the San Francisco Fed’s version of the Taylor rule, which relates the interest rate to the inflation rate and the unemployment rate. The green line shows the actual federal funds rate. The actual rate tracked the predicted rate quite closely through the end of 2008. After that, however, the Taylor rule called for negative interest rates, which aren’t possible.

Sources: Bureau of Labor Statistics; Congressional Budget Office; Federal Reserve Bank of St. Louis; Glenn D. Rudebusch, “The Fed’s Monetary Policy Response to the Current Crisis,” FRBSF Economic Letter #2009-17 (May 22, 2009).

Inflation Targeting

Until January 2012, the Fed did not explicitly commit itself to achieving a particular inflation rate. However, in January 2012, the Fed chairman at the time, Ben Bernanke, announced that the Fed would set its policy to maintain an approximately 2% inflation rate per year. With that statement, the Fed joined a number of other central banks that have explicit inflation targets.

So rather than using a Taylor rule to set monetary policy, they instead announced the inflation rate that they want to achieve—the inflation target—and set policy in an attempt to hit that target. This method of setting monetary policy, called inflation targeting, involves having the central bank announce the inflation rate it is trying to achieve and set policy in an attempt to hit that target. The central bank of New Zealand, which was the first country to adopt inflation targeting, specified a range for that target of 1% to 3%.

Other central banks commit themselves to achieving a specific number. For example, the Bank of England has committed to keeping inflation at 2%. In practice, there doesn’t seem to be much difference between these versions: central banks with a target range for inflation seem to aim for the middle of that range, and central banks with a fixed target tend to give themselves considerable wiggle room.

One major difference between inflation targeting and the Taylor rule method is that inflation targeting is forward-looking rather than backward-looking. That is, the Taylor rule method adjusts monetary policy in response to past inflation, but inflation targeting is based on a forecast of future inflation.

Advocates of inflation targeting argue that it has two key advantages over a Taylor rule: transparency and accountability. First, economic uncertainty is reduced because the central bank’s plan is transparent: the public knows the objective of an inflation-targeting central bank. Second, the central bank’s success can be judged by seeing how closely actual inflation rates have matched the inflation target, making central bankers accountable.

Critics of inflation targeting argue that it’s too restrictive because there are times when other concerns—like the stability of the financial system—should take priority over achieving any particular inflation rate. Indeed, in late 2007 and early 2008 the Fed cut interest rates much more than either a Taylor rule or inflation targeting would have dictated because it feared that turmoil in the financial markets would lead to a major recession. (In fact, it did.)

Many American macroeconomists have had positive things to say about inflation targeting—including Bernanke. And in January 2012 the Fed declared that what it means by the “price stability” it seeks is 2 percent inflation, although there was no explicit commitment about when this inflation rate would be achieved.

The Zero Lower Bound Problem

As Figure 74-6 shows, a Taylor rule based on inflation and the unemployment rate does a good job of predicting Federal Reserve policy from 1988 through 2008. After that, however, things go awry, and for a simple reason: with very high unemployment and low inflation, the same Taylor rule called for an interest rate less than zero, which isn’t possible.

Since 2012, the Fed has targeted inflation at 2%.

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Why aren’t negative interest rates possible? Because people always have the alternative of holding cash, which offers a zero interest rate. Nobody would ever buy a bond yielding an interest rate less than zero because holding cash would be a better alternative.

The fact that interest rates can’t go below zero—called the zero lower bound for interest rates—sets limits to the power of monetary policy. In 2009 and 2010, inflation was low and the economy was operating far below potential, so the Federal Reserve wanted to increase aggregate demand. Yet the normal way it does this—open-market purchases of short-term government debt to expand the money supply—had run out of room to operate because short-term interest rates were already at or near zero.

In November 2010 the Fed began an attempt to circumvent this problem, which went by the somewhat obscure name quantitative easing. Instead of purchasing only short-term government debt, it began buying longer-term government debt—five-year or six-year bonds, rather than three-month Treasury bills.

As we have already pointed out, long-term interest rates don’t exactly follow short-term rates. At the time the Fed began this program, short-term rates were near zero, but rates on longer-term bonds were between 2% and 3%. The Fed hoped that direct purchases of these longer-term bonds would drive down interest rates on long-term debt, exerting an expansionary effect on the economy.

Long-term interest rates did decline to about 1% in 2010, then rose back up to 2% in 2011, before once again returning to 1% where they stayed until mid-2013. Although the Fed’s policy may have boosted spending from 2010 to 2013, recovery remained slow.

WHAT THE FED WANTS, THE FED GETS

What’s the evidence that the Fed can actually cause an economic contraction or expansion? You might think that finding such evidence is just a matter of looking at what happens to the economy when interest rates go up or down. But it turns out that there’s a big problem with that approach: the Fed usually changes interest rates in an attempt to tame the business cycle, raising rates if the economy is expanding and reducing rates if the economy is slumping. So in the actual data, it often looks as if low interest rates go along with a weak economy and high rates go along with a strong economy.

In a famous paper titled “Monetary Policy Matters,” the macroeconomists Christina Romer and David Romer solved this problem by focusing on episodes in which monetary policy wasn’t a reaction to the business cycle. Specifically, they used minutes from the Federal Open Market Committee and other sources to identify episodes “in which the Federal Reserve in effect decided to attempt to create a recession to reduce inflation.”

Rather than just using monetary policy as a tool of macroeconomic stabilization, sometimes it is used to eliminate embedded inflation—inflation that people believe will persist into the future. In such a case, the Fed needs to create a recessionary gap—not just eliminate an inflationary gap—to wring embedded inflation out of the economy.

Figure 74-7 shows the unemployment rate between 1952 and 1984 (orange) and also identifies five dates on which, according to Romer and Romer, the Fed decided that it wanted a recession (vertical red lines). In four out of the five cases, the decision to contract the economy was followed, after a modest lag, by a rise in the unemployment rate. On average, Romer and Romer found, the unemployment rate rises by 2 percentage points after the Fed decides that unemployment needs to go up.

Sources: Bureau of Labor Statistics; Christina D. Romer and David H. Romer, “Monetary Policy Matters,” Journal of Monetary Economics 34 (August 1994): 75–88.

So yes, the Fed gets what it wants.

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Check Your Understanding

PITFALLS: THE TARGET VERSUS THE MARKET

THE TARGET VERSUS THE MARKET

Over the years, the Federal Reserve has changed the way in which monetary policy is implemented. In the late 1970s and early 1980s, it set a target level for the money supply and altered the monetary base to achieve that target. Under this way of operating, the federal funds rate fluctuated freely. Today the Fed uses the reverse procedure, setting a target for the federal funds rate and allowing the money supply to fluctuate as it pursues that target. Do these changes in the way the Fed operates alter the way the money market works?

NOT AT ALL. THE MONEY MARKET WORKS THE SAME WAY AS ALWAYS: THE INTEREST RATE IS DETERMINED BY THE SUPPLY AND DEMAND FOR MONEY. THE ONLY DIFFERENCE IS THAT NOW THE FED ADJUSTS THE SUPPLY OF MONEY TO ACHIEVE ITS TARGET INTEREST RATE Although you may hear people say that the interest rate no longer reflects the supply and demand for money because the Fed sets the interest rate, this is a common misconception. It’s important not to confuse a change in the Fed’s operating procedure with a change in the way the economy works.

To learn more, see pages 392–394.