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? In Chapter 6 we learned that 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 15-8 shows the U.S. output gap, which we defined in Chapter 12 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.

Tracking Monetary Policy Using the Output Gap and Inflation 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.
Source: 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 15-8 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.