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
- 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. - 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.