AP_Krugman_Textbook

Figure 31.2 shows how interest rate targeting works. In both panels, rTis the target

federal funds rate. In panel (a), the initial money supply curve is MS 1 with money sup-

plyM 1 , and the equilibrium interest rate, r 1 , is above the target rate. To lower the in-

terest rate to rT,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

308 section 6 Inflation, Unemployment, and Stabilization Policies

figure 31.1

The Effect of an Increase

in the Money Supply on

the Interest Rate

The Federal Reserve can lower the inter-

est rate by increasing the money supply.

Here, the equilibrium interest rate falls

fromr 1 tor 2 in response to an increase in

the money supply from M 1 toM 2. In

order to induce people to hold the larger

quantity of money, the interest rate must

fall from r 1 tor 2.

M 2 Quantity

of money

r 1

r 2

Interest

rate, r

E 2

E 1

MS 1

MD

MS 2

M 1

An increase

in the money

supply...

... leads to
a fall in the
interest rate.

M 2 Quantity

of money

r 1

rT

Interest

rate, r

E 2

E 1

MS 1

MD

MS 2

M 1

An open-market

purchase...

M 1 Quantity

of money

r 1

rT

Interest

rate, r

E 1

E 2

MS 2

MD

MS 1

M 2

An open-market

sale...

(a) Pushing the Interest Rate

Down to the Target Rate

(b) Pushing the Interest Rate

Up to the Target Rate

... drives
the
interest
rate up.
... drives
the
interest
rate down.

figure 31.2 Setting the Federal Funds Rate

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 rT. In panel (a) the initial equilib-

rium interest rate, r 1 , is above the target rate. The Fed in-

creases the money supply by making an open - market purchase

of Treasury bills, pushing the money supply curve rightward,

fromMS 1 toMS 2 , and driving the interest rate down to rT. In

panel (b) the initial equilibrium interest rate, r 1 , 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 MS 1 toMS 2 , and driving the interest rate

up to rT.