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The Fed Reverses Course
During the summer of 2007, many called for a age effective rate that prevailed in the market Open Market Committee set a target range for
change in Federal Reserve policy. At first the Fed each day. The figure shows that the interest rate the federal funds rate, between 0% and 0.25%,
remained unmoved. On August 7, 2007, the Fed- cut six weeks after Cramer’s diatribe was only starting on that date. That target range was still
eral Open Market Committee decided to stand the first of several cuts. As you can see, this in effect at the time of writing.
pat, making no change in its interest rate policy. was a reversal of previous policy: previously the The figure also shows that that the Fed
The official statement did, however, concede that Fed had generally been raising rates, not reduc- doesn’t always hit its target. There were a num-
“financial markets have been volatile in recent ing them, out of concern that inflation might be- ber of days, especially in 2008, when the actual
weeks” and that “credit conditions have become come a problem. But starting in September federal funds rate was significantly above or
tighter for some households and businesses.” 2007, fighting the financial crisis took priority. below the target rate. But these episodes didn’t
Just three days later, the Fed issued a special By the way, notice how beginning on December last long, and overall the Fed got what it
statement basically assuring market players 16, 2008, it looks as if there are two target fed- wanted, at least as far as short-term interest
that it was paying attention, and on August 17 it eral funds rates. What happened? The Federal rates were concerned.
issued another statement declaring that it
was “monitoring the situation,” which is Federal
Fed - speak for “we’re getting nervous.” funds
rate
And on September 18, the Fed did what
CNBC analyst Jim Cramer wanted: it cut 6%
the target federal funds rate “to help fore-
5
stall some of the adverse effects on the
broader economy that might otherwise
4
arise from the disruptions in financial mar-
kets.” In effect, it conceded that Cramer’s 3 Effective federal funds rate
worries were at least partly right.
It was the beginning of a major change 2
in monetary policy. The figure shows two
interest rates from the beginning of 2004 1 Target federal funds rate
to early 2010: the target federal funds rate
decided by the Federal Open Market Com-
mittee, which dropped in a series of steps 2004 2005 2006 2007 2008 2009 2010
starting in September 2007, and the aver- Year

panel (a) by the rightward shift of the money supply curve from MS 1 to MS 2 and an in-

crease in the money supply to M 2. This drives the equilibrium interest rate down to the
target rate, r T .
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, r T . 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 to MS 2 , driving the equilibrium interest rate up to the
target federal funds rate, r T .

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