AP_Krugman_Textbook

module 31 Monetary Policy and the Interest Rate 313

What the Fed Wants, the Fed Gets

What’s the evidence that the Fed can actually

cause an economic contraction or expansion?

You might think that finding such evidence is just

a matter of looking at what happens to the econ-

omy when interest rates go up or down. But it

turns out that there’s a big problem with that ap-

proach: the Fed usually changes interest rates

in an attempt to tame the business cycle,

raising rates if the economy is expanding and re-

ducing rates if the economy is slumping. So in

the actual data, it often looks as if low interest

rates go along with a weak economy and

high rates go along with a strong economy.

In a famous 1994 paper titled “Monetary

Policy Matters,” the macroeconomists

Christina Romer and David Romer solved

this problem by focusing on episodes in

which monetary policy wasn’ta reaction to

the business cycle. Specifically, they used

minutes from the Federal Open Market Com-

mittee and other sources to identify episodes

“in which the Federal Reserve in effect de-

cided to attempt to create a recession to re-

duce inflation.” Contractionary monetary

policy is sometimes used to eliminate infla-

tion that has become embeddedin the econ-

omy, rather than just as a tool of macroeco-

nomic stabilization. In this case, the Fed needs

to create a recessionary gap—not just elimi-

nate an inflationary gap—to wring embedded

inflation out of the economy.

The figure shows the unemployment rate be-

tween 1952 and 1984 (orange) and identifies

five dates on which, according to Romer and

Romer, the Fed decided that it wanted a reces-

sion (vertical red lines). In four out of the five

cases, the decision to contract the economy

was followed, after a modest lag, by a rise in

the unemployment rate. On average, Romer and

Romer found, the unemployment rate rises by 2

percentage points after the Fed decides that un-

employment needs to go up.

So yes, the Fed gets what it wants.

fyi

12%

10

8

6

4

2

Unemploy-

ment rate

Year

19521954195619581960196219641966196819701972197419761978198019821984

Module 31 AP Review

Check Your Understanding

1. Assume that there is an increase in the demand for money at
   every interest rate. Using a diagram, show what effect this will
   have on the equilibrium interest rate for a given money supply.


2. Now assume that the Fed is following a policy of targeting the
   federal funds rate. What will the Fed do in the situation
   described in question 1 to keep the federal funds rate
   unchanged? Illustrate with a diagram.
   3. Suppose the economy is currently suffering from a recessionary
   gap and the Federal Reserve uses an expansionary monetary
   policy to close that gap. Describe the short -run effect of this
   policy on the following.
   a. the money supply curve
   b. the equilibrium interest rate
   c. investment spending
   d. consumer spending
   e. aggregate output

Solutions appear at the back of the book.