panel (a) by the rightward shift of the money supply curve from MS 1 toMS 2 and an in-
crease in the money supply to M2.This drives the equilibrium interest rate downto the
target rate, rT.
Panel (b) shows the opposite case. Again, the initial money supply curve is MS 1 with
money supply M 1. But this time the equilibrium interest rate, r 1 , is below the target fed-
eral funds rate, rT.In this case, the Fed will make an open - market sale of Treasury bills,
leading to a fall in the money supply to M 2 via the money multiplier. The money supply
curve shifts leftward from MS 1 toMS 2 , driving the equilibrium interest rate upto the
target federal funds rate, rT.
Monetary Policy and Aggregate Demand
We have seen how fiscal policy can be used to stabilize the economy. Now we will see
how monetary policy—changes in the money supply or the interest rate, or both—can
play the same role.
module 31 Monetary Policy and the Interest Rate 309
The Fed Reverses Course
During the summer of 2007, many called for a
change in Federal Reserve policy. At first the Fed
remained unmoved. On August 7, 2007, the Fed-
eral Open Market Committee decided to stand
pat, making no change in its interest rate policy.
The official statement did, however, concede that
“financial markets have been volatile in recent
weeks” and that “credit conditions have become
tighter for some households and businesses.”
Just three days later, the Fed issued a special
statement basically assuring market players
that it was paying attention, and on August 17 it
issued another statement declaring that it
was “monitoring the situation,” which is
Fed - speak for “we’re getting nervous.”
And on September 18, the Fed did what
CNBC analyst Jim Cramer wanted: it cut
the target federal funds rate “to help fore-
stall some of the adverse effects on the
broader economy that might otherwise
arise from the disruptions in financial mar-
kets.” In effect, it conceded that Cramer’s
worries were at least partly right.
It was the beginning of a major change
in monetary policy. The figure shows two
interest rates from the beginning of 2004
to early 2010: the target federal funds rate
decided by the Federal Open Market Com-
mittee, which dropped in a series of steps
starting in September 2007, and the aver-age effective rate that prevailed in the market
each day. The figure shows that the interest rate
cut six weeks after Cramer’s diatribe was only
the first of several cuts. As you can see, this
was a reversal of previous policy: previously the
Fed had generally been raising rates, not reduc-
ing them, out of concern that inflation might be-
come a problem. But starting in September
2007, fighting the financial crisis took priority.
By the way, notice how beginning on December
16, 2008, it looks as if there are two target fed-
eral funds rates. What happened? The FederalOpen Market Committee set a target rangefor
the federal funds rate, between 0% and 0.25%,
starting on that date. That target range was still
in effect at the time of writing.
The figure also shows that that the Fed
doesn’t always hit its target. There were a num-
ber of days, especially in 2008, when the actual
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.fyi
6%54321Federal
funds
rateYear2004 2005 2006 2007 2008 2009 2010Effective federal funds rateTarget federal funds rate