12.5 Monetary Policy and Economic Outcomes

The Effect of Monetary Policy on Interest Rates

Consider the market for loanable bank funds in Figure 12.13. The original equilibrium (E₀) occurs at an 8% interest rate and a quantity of funds loaned and borrowed of $10 billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S₀) to S₁, leading to an equilibrium (E₁) with a lower 6% interest rate and a quantity $14 billion in loaned funds. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S₀) to S₂, leading to an equilibrium (E₂) with a higher 10% interest rate and a quantity of $8 billion in loaned funds.

How does a central bank “raise” interest rates? When describing the central bank’s monetary policy actions, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.” We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, Figure 12.13 shows that interest rates change. If they do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do. When this traditional method of open market operations fails to have the desired impact on the federal funds rate the central bank can make changes to the interest rate on reserve balances (IORB) which will cause a corresponding change to the federal funds rate.

Recall that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations.  In recent years the central bank has announced their intentions before taking steps to change the FFR.  In March 2022 the federal reserve announced that it would be increasing the FFR by 25 basis points or 0.25%.  This move was accomplished by adjusting the IORB from 0.15% to 0.40% which in turn caused the FFR to rise from 0.8% to 0.33%.

Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.

The Effect of Monetary Policy on Aggregate Demand

Whichever tool the federal reserve chooses to use monetary policy will ultimately affect interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items.

If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP.  Figure 12.14 (a) illustrates this situation. This example uses a short-run upward-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of E₀ occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD₀) to shift right to AD₁, so that the new equilibrium (E₁) occurs at the potential GDP level of 700.

Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In Figure 12.14 (b), the original equilibrium (E₀) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD₀) to shift left to AD₁, so that the new equilibrium (E₁) occurs at the potential GDP level of 700.

These examples suggest that monetary policy should be countercyclical; that is, it should act to counterbalance the business cycles of economic downturns and upswings. The Fed should loosen monetary policy when a recession has caused unemployment to increase and tighten it when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. There is speculation that this could have been the case in 2020 when the reacted to the COVID-19 recession by quickly dropping the FFR from around 1.5% down to 0.05% in just a few months. If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. Figure 12.15 (a) and (b) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level.

Federal Reserve Actions Over Last Four Decades

For the period from the mid-1970s up through the end of 2007, we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations.

Of course, telling the story of the U.S. economy since 1975 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and inflation over this time. The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U.S. economy is probably the Federal Reserve chairperson.

Figure 12.16 shows how the Federal Reserve has carried out monetary policy by targeting the federal funds interest rate from 1970 through 2014. The graph shows the federal funds interest rate (this interest rate was set through open market operations), the unemployment rate, and the inflation rate. Different episodes of monetary policy during this period are indicated in the figure.

Episode 1

Consider Episode 1 in the late 1970s. The rate of inflation was very high, exceeding 10% in 1979 and 1980, so the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds rate rising from 5.5% in 1977 to 16.4% in 1981. By 1983, inflation was down to 3.2%, but aggregate demand contracted sharply enough that back-to-back recessions occurred in 1980 and in 1981–1982, and the unemployment rate rose from 5.8% in 1979 to 9.7% in 1982.

Episode 2

In Episode 2, when economists persuaded the Federal Reserve in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest rate fell from 16.4% in 1981 to 6.8% in 1986. By 1986 or so, inflation had fallen to about 2% and the unemployment rate had come down to 7%, and was still falling.

Episode 3

However, in Episode 3 in the late 1980s, inflation appeared to be creeping up again, rising from 2% in 1986 up toward 5% by 1989. In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6.6% in 1987 to 9.2% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but it also helped to cause the 1990-1991 recession, and the unemployment rate rose from 5.3% in 1989 to 7.5% by 1992.

Episode 4

In Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to 3.5% in 1992. As the economy expanded, the unemployment rate declined from 7.5% in 1992 to less than 5% by 1997.

Episodes 5 and 6

In Episodes 5 and 6, the Federal Reserve perceived a risk of inflation and raised the federal funds rate from 3% to 5.8% from 1993 to 1995. Inflation did not rise, and the period of economic growth during the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4.6% in December 1998 to 6.5% in June 2000. By early 2001, inflation was declining again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0% to 5.8%.

Episodes 7 and 8

In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2% in 2000 to just 1.7% in 2002, and then again to 1% in 2003. They actually did this because of fear of Japan-style deflation. This persuaded them to lower the Fed funds further than they otherwise would have. The recession ended, but, unemployment rates were slow to decline in the early 2000s. Finally, in 2004, the unemployment rate declined and the Federal Reserve began to raise the federal funds rate until it reached 5% by 2007.

Episode 9

In Episode 9, as the Great Recession took hold in 2008, the Federal Reserve was quick to slash interest rates, taking them down to 2% in 2008 and to nearly 0% in 2009. When the Fed had taken interest rates down to near-zero by December 2008, the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The Federal Reserve had to implement innovative and nontraditional policy called quantitative easing or  large-scale asset purchases to stimulate the economy and bring the unemployment rate down.

Episode 10 – see Figure 12.17

In Episode 10, recovery from the Great Recession was very slow so the Federal Reserve kept interest rates at or near zero from 2010 through the end of 2015.  Once unemployment back down to 5% the Fed changed course and began taking steps to increase the in FFR moving it from near 0% in 2015 to 2.4% in 2019. During this period unemployment continued to fall so the upward movement of the FFR did not have a contractionary or tightening effect, it was a move to bring the rate away from zero so that it could once again be used as a tool for monetary policy.

Episode 11 – see Figure 12.17

In Episode 11, the COVID-19 Recession caused a sudden shock to the economy lasting only 2 months, February 2020 to April 2020. As the unemployment rate rose from an historic low of 3.5% in February to an historic high of 14.7% in April, the Federal Reserve was quick to slash interest rates, driving the FFR down to 0.05%. This was achieved through another round of quantitative easing or LSAP,  increased overnight repurchase agreements, dropping the interest paid on reserve balances IORB to near zero, and decreasing the reserve requirement to 0% in March 2020. These swift changes helped the economy bounce back from a second quarter GDP decline of 31.2% to an increase of 33.8%.

Episode 12 – still unfolding in 2022