Module 31
Monetary Policy and
the Interest Rate
In Modules 28 and 29 we developed models of the money market and the loanable
funds market. We also saw how these two markets are consistent and related. In the
short run, the interest rate is determined in the money market and the loanable funds
market adjusts in response to changes in the money market. However, in the long run,
the interest rate is determined by matching the supply and demand of loanable funds
that arise when real GDP equals potential output. Now we are ready to use these mod-
els to explain how the Federal Reserve can use monetary policy to stabilize the econ-
omy in the short run.
Monetary Policy and the Interest Rate
Let’s examine how the Federal Reserve can use changes in the money supply to change
the interest rate. Figure 31.1 on the next page shows what happens when the Fed in-
creases the money supply from M 1 toM 2. The economy is originally in equilibrium at
E 1 , with the equilibrium interest rate r 1 and the money supply M 1. An increase in the
money supply by the Fed to M 2 shifts the money supply curve to the right, from MS 1 to
MS 2 , and leads to a fall in the equilibrium interest rate to r 2. Why? Because r 2 is the only
interest rate at which the public is willing to hold the quantity of money actually sup-
plied,M 2. 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 sup-
ply up or down, the Fed can set the interest rate.
In practice, at each meeting the Federal Open Market Committee decides on the in-
terest 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 en-
forced by the Open Market Desk of the Federal Reserve Bank of New York, which ad-
justs 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 mon-
etary policy, lending through the discount window and changes in reserve require-
ments, aren’t used on a regular basis (although the Fed used discount window lending
in its efforts to address the 2008 financial crisis).
What you will learn
in this Module:
- How the Federal Reserve
implements monetary policy,
moving the interest rate to
affect aggregate output - Why monetary policy is
the main tool for stabilizing
the economy
module 31 Monetary Policy and the Interest Rate 307
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.