The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2¼ percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

So read the beginning of a press release from the Federal Reserve issued on March 18, 2008. (A basis point is equal to 0.01 percentage point. So the statement implies that the Fed lowered the target from 3% to 2.25%.) We learned about the federal funds rate in Chapter 29: it’s the rate at which banks lend reserves to each other to meet the required reserve ratio. As the statement implies, at each of its eight-times-a-year meetings, a group called the Federal Open Market Committee sets a target value for the federal funds rate. It’s then up to Fed officials to achieve that target. This is done by the Open Market Desk at the Federal Reserve Bank of New York, which buys and sells short-term U.S. government debt, known as Treasury bills, to achieve that target.

As we’ve already seen, other short-term interest rates, such as the rates on CDs, move with the federal funds rate. So when the Fed reduced its target for the federal funds rate from 3% to 2.25% in March 2008, many other short-term interest rates also fell by about three-quarters of a percentage point.

How does the Fed go about achieving a target federal funds rate? And more to the point, how is the Fed able to affect interest rates at all?

Recall that, for simplicity, we’re assuming there is only one interest rate paid on nonmonetary financial assets, both in the short run and in the long run. To understand how the interest rate is determined, consider Figure 30-3, which illustrates the liquidity preference model of the interest rate; this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 30-3 combines the money demand curve, MD, with the money supply curve, MS, which shows how the quantity of money supplied by the Federal Reserve varies with the interest rate.

In Chapter 29 we learned how the Federal Reserve can increase or decrease the money supply: it usually does this through open-market operations, buying or selling Treasury bills, but it can also lend via the discount window or change reserve requirements. Let’s assume for simplicity that the Fed, using one or more of these methods, simply chooses the level of the money supply that it believes will achieve its interest rate target. Then the money supply curve is a vertical line, MS in Figure 30-3, with a horizontal intercept corresponding to the money supply chosen by the Fed, . The money market equilibrium is at E, where MS and MD cross. At this point the quantity of money demanded equals the money supply, , leading to an equilibrium interest rate of r_E.

To understand why r_E is the equilibrium interest rate, consider what happens if the money market is at a point like L, where the interest rate, r_L, is below r_E. At r_L the public wants to hold the quantity of money M_L, an amount larger than the actual money supply, . This means that at point L, the public wants to shift some of its wealth out of interest-bearing assets such as CDs into money.

This result has two implications. One is that the quantity of money demanded is more than the quantity of money supplied. The other is that the quantity of interest-bearing money assets demanded is less than the quantity supplied. So those trying to sell nonmoney assets will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from r_L until the public wants to hold the quantity of money that is actually available, . That is, the interest rate will rise until it is equal to r_E.

Now consider what happens if the money market is at a point such as H in Figure 30-3, where the interest rate r_H is above r_E. In that case the quantity of money demanded, M_H, is less than the quantity of money supplied, . Correspondingly, the quantity of interest-bearing nonmoney assets demanded is greater than the quantity supplied. Those trying to sell interest-bearing nonmoney assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from r_H. It falls until the public wants to hold the quantity of money that is actually available, . Again, the interest rate will end up at r_E.

You might have noticed that this is the second time we have discussed the determination of the interest rate. In Chapter 25 we studied the loanable funds model of the interest rate; according to that model, the interest rate is determined by the equalization of the supply of funds from lenders and the demand for funds by borrowers in the market for loanable funds. But here we have described a seemingly different model in which the interest rate is determined by the equalization of the supply and demand for money in the money market. Which of these models is correct?

The answer is both. We explain how the models are consistent with each other in the appendix to this chapter. For now, let’s put the loanable funds model to one side and concentrate on the liquidity preference model of the interest rate. The most important insight from this model is that it shows us how monetary policy—actions by the Federal Reserve and other central banks—works.

Let’s examine how the Federal Reserve can use changes in the money supply to change the interest rate. Figure 30-4 shows what happens when the Fed increases the money supply from to . The economy is originally in equilibrium at E₁, with an equilibrium interest rate of r₁ and 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 —in those two small rooms we mentioned in the opening story—which adjusts the money supply through the purchase and 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 30-5 shows how this 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. As we learned in Chapter 29, 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.

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.

Earlier in this chapter 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.

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 the 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, as they were in 2014, 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. As we learned in Chapter 25, 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).

As we will see later in this chapter, the fact that long-term rates don’t necessarily move with short-term rates is sometimes an important consideration for monetary policy.