12.

1​The Federal Reserve System

Unless you are very rich or very poor, you come into contact with the Federal Reserve
every day. Reach in your pocket and pull out a dollar bill (or a 5- or 10-dollar bill). What
does it say, right there across the top, on the front?

​The Federal Reserve is the U.S. central bank—a bank for commercial banks—with the
primary responsibility of maintaining a stable and effective monetary system. One of its
tasks is to distribute “Federal Reserve Notes”—the U.S. currency. It is an unusual
institution, and one that is the result of extensive debates about the nature and power of
banking and financial systems in the United States. It represents the outcomes of a long
history of political compromise dating from the first bank of the United States
established in 1791 and continuing through the creation of the current Federal Reserve
in 1913 and the Federal Reserve System in its current form. Much of the early debate
was among eastern U.S. banking and financial interests and the small businesses and
farms of the west and south. The result is a partially private, partially public institution
that is decentralized yet has a strong centralized core.
 Figure 12.2: Board members meet on June 3, 2016, to discuss advance notice of
proposed rule making and notice of proposed rule making. Janet Yellen, the former
chair (and first female chair), and Jerome Powell, current chair of the Fed, are at the
meeting. [2]

The Federal Reserve System, often referred to simply as “the Fed,” consists of a board
of governors in Washington and 12 Federal Reserve Banks in Boston, New York,
Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas
City, Dallas, and San Francisco (see Figure 12.3 for a map of each bank's region). The
board of governors is at the top of the management structure. The seven members of
the board of governors are appointed by the president and approved by the Senate. The
terms are long (14 years) and the governors cannot be removed except through
extraordinarily difficult impeachment processes. One governor’s term expires every
other year, the intended result of which is a slow but steady turnover and significant
independence from political pressure.
 Figure 12.3:
A map of the 12 U.S. Federal Reserve regional banks and their corresponding regions.
[3]​​

​The president, with the approval of the Senate, also appoints one of the board members
as chair. President Trump nominated the current Fed chair, Jerome "Jay" Powell, in the
fall of 2017. He was confirmed by the Senate and took office in February 2018. Prior to
that, he served as a member of the board of governors under his predecessor, Janet
Yellen. Unlike the prior two chairs (Janet Yellen and Ben Bernanke), whose careers
began as academic economists, Powell's prior experience was mainly in investment
banking.

The board of governors, with the input and involvement of the board staff and the
presidents and staffs of the 12 Federal Reserve banks, is responsible for the design and
implementation of monetary policy. It also engages in bank regulatory and supervisory
activities, the setting of margin requirements for equity markets (limits on how much can
be borrowed when purchasing stocks and bonds), and a variety of consumer protection
efforts.
The 12 Federal Reserve banks were originally intended as the operating arms or the
decentralized portion of the Federal Reserve. The individual banks clear checks and
manage electronic transfers, distribute currency, and engage in regulation of private
banks. They also play roles, along with the board of governors, in establishing monetary
policy. The banks are managed by their own boards consisting of six people elected by
member banks of the respective Federal Reserve district and three members appointed
by the board of governors. Three of the banks have only one location; all of the others
have branches in other cities.

Although the Fed received its charter with the Federal Reserve Act of 1913 and this
charter could be dissolved by an act of Congress, the whole system operates largely
independently of the federal government. Congress established the Federal Reserve’s
statutory objectives: “maximum employment, stable prices, and moderate long-term
interest rates.” However, it is free to achieve this objective (which is not very precise to
begin with) in whatever way it sees fit. Its monetary policy actions are not subject to
Congressional approval, its funding comes from its own earnings, and members of its
governing body serve long terms. The reason it is so important for a central bank to be
independent is that monetary policy decisions necessary to achieve the goal of stable
prices are not always popular and may go against the prevailing political winds. The
Federal Open Market Committee (FOMC), the committee that bears the most
responsibility for choosing the course of monetary policy, often has to make politically
unpopular choices.

Still, the chair and governors do regularly testify to Congress and report on their goals,
their interpretations of economic conditions, and their operations. The chair and others
work closely with the U.S. Department of the Treasury on a number of regulatory issues
and international financial interactions. In addition, there is always the possibility of
Congress changing the law to make the Federal Reserve less independent (perhaps as
part of the U.S. Department of the Treasury), to change the composition of the board of
governors, or even to abolish the system. For that reason, the Fed, like all central
banks, seldom tries to resist a political consensus. Their independence from politics is
not as strong as, for example, the U.S. Supreme Court's independence.

The following video gives a very brief overview of the material we will cover below:

For a written transcript of this video, click here.

12.2 Federal Reserve Tools

​It is the monetary policyrole of the Federal Reserve that we focus on in this chapter.
Monetary policy is the activity of the Federal Reserve System intended to change the
growth of the nation’s money supply to foster full employment, stable prices, and a
sound financial system. The Fed has four primary toolsit uses to achieve these goals:

● ​Open market operations

● Discount rate
 ● Required reserve ratio
● Interest on excess reserves (which is a relatively new tool)

We will begin with open market operations and then eventually get to the other,
generally less important, policy options.

12.2.1​Open Market Operations

​Open market operations consist of the Federal Reserve “operating” (i.e., buying and
selling existing federal government bonds) in the “open market” for bonds. A group
within the Federal Reserve System with the title Federal Open Market Committee
(FOMC) manages open market operations. The committee is made up of the seven
governors of the Federal Reserve and an additional five members who are currently
serving as Federal Reserve bank presidents. The New York Federal Reserve Bank
president normally serves as the vice-chair, and the other bank presidents rotate on and
off the committee. The committee meets in regularly scheduled meetings approximately
every six weeks and has conference calls in between.

12.2.1.1 ​Influencing the Money Supply

If the FOMC determines that it should expand the money supply, it will buy U.S.
Treasury bonds. Once purchased, these bonds can be resold to any buyer. The Fed
can be that buyer, but it does not buy bonds directly from the Treasury. If it wishes to
contract the money supply, it will sell bonds.

When the Federal Reserve buys bonds, it notifies all of its primary dealers through an
electronic system called FedTrade, inviting dealers to submit an offer. The Fed will buy
bonds from the lowest offers (step 1 in Figure 12.4). The Federal Reserve, in essence,
pays the dealers for the bonds with a check. The dealers have most likely sold the
bonds on behalf of individuals, financial institutions, and businesses, so the dealers, in
turn, give those checks to the former owners of the bonds. The checks are deposited in
banks (step 3). Bank deposits increase (step 4). Banks present those checks to the
Federal Reserve (step 5), and the Federal Reserve increases the banks’ reserves by
equivalent amounts (step 6). The money supply (which includes the number of deposits)
increases by an amount equal to the purchase of bonds.

Figure 12.4:
This visual representation of open market operations shows the process.

Question 12.01
Question 12.1
Think back to our discussion of money creation in Chapter 11. What will ultimately
happen to the money supply as a result of this “open market purchase”?

Hover here to see the hint for Question 12.01.

Click here to see the answer to Question 12.01.
Question 12.02
Question 12.2
See if you can explain the reverse process. What if the Federal Reserve wishes to
reduce the money supply?

Hover here to see the hint for Question 12.02.

Click here to see the answer to Question 12.02.

12.2.1.2 ​The Federal Funds Rate

The Federal Reserve almost always communicates its plans by announcing a new
target for the federal funds rate. It is a means of signaling the direction of a change in
the stance of monetary policy. As you will see below, the Fed achieves its target for the
federal funds rate by buying or selling bonds.

Federal funds are the portion of reserve balances that are held by commercial banks at
Federal Reserve banks. Some banks will have excess reserves, while others will have
insufficient reserves to meet reserve requirements. Banks with excess reserves can
lend those reserves to other institutions by asking the Federal Reserve to transfer
reserves electronically to the borrowing bank. The borrowing institution will return the
reserves along with interest, often the next day. The interest rate that banks charge
each other for such loans is called the federal funds rate.
The federal funds rate is not directly set by the Federal Reserve, but it is highly sensitive
to the Federal Reserve’s open market operations. For example, if the Fed announces a
reduction in its target for the federal funds rate, it will achieve this objective by buying
bonds. Figure 12.5 shows the market for overnight bank reserves. Demand for reserves
reflects banks' demand to borrow reserves overnight from other banks. When the
interest rate (federal funds rate) on those loans is high, the quantity demanded is low,
and vice versa. When the Fed buys bonds, it exchanges bonds for cash, and that cash
then becomes excess reserves in the banking system, which banks can then supply for
overnight borrowing. At the old federal funds rate, the quantity of funds supplied
exceeds the quantity demanded, and the federal funds rate falls as a result. This
increases the number of excess reserves available for lending to other banks, ultimately
leads to a reduction in the interest rate charged on these loans.

Figure 12.5: The market for federal

funds. The quantity of reserves increases when the Federal Reserve buys bonds.

The process works similarly in reverse. When the Federal Reserve sells bonds, bank
reserves are taken out of the banking system. This lowers the excess reserves available
for lending, which will raise the interest rate charged on those funds. So keep in mind
that although the Fed often announces changes in interest rates, they are really
announcing plans to buy or sell bonds to influence interest rates and the money supply.

12.2.1.3 Bond Prices and Interest Rates

The selling and buying of bonds by the Federal Reserve have another means of
affecting market interest rates. Think back to our discussion about the pricing of bonds
in Chapter 11: Money. The main thing to remember is that a bond’s price and the
interest rate earned by the owners of that bond (sometimes referred to as the yield to
maturity, or simply “bond yields”) move in opposite directions.

For the sake of review, recall that the bond issuer (the borrower) promises to pay the
lender a fixed amount (the bond’s par value or face value) when the bond matures.
Many bonds also make periodic coupon payments. For this simple review, let’s consider
a particular kind of bond called a Treasury bill. A one-year Treasury bill promises to
make a single payment of $1,000 one year from now. If investors require a 5 percent
rate of return on this loan, they would be willing to pay at most $952.38 for this bond. To
see why, note that the only way to make exactly 5 percent interest on an investment that
will pay exactly $1,000 in one year is to pay exactly $952.38 for the investment.

Because of the relationship between bond prices and their interest rates, a sale of
bonds raises the effective interest rate on Treasury bonds the Fed buys and sells (see
Figure 12.6). But the story doesn’t end there. Treasury bonds are close substitutes to
other types of bonds in the bond market. As the rate of return on Treasury bonds
increases, owners of other types of bonds may sell their bonds and buy Treasury bonds.
The increase in the supply of the other bonds lowers their prices and raises the interest
rate on the other bonds.
 Figure 12.6: Bond supply and demand.
An increase in the supply of bonds causes bond prices to fall, and this means that the
bonds' interest rate will increase.

A decision by the Federal Reserve to sell bonds affects interest rates in three ways:
First, by reducing the supply of money; second, by restricting excess reserves that
banks have available to loan to each other and thus raising the federal funds rate; and
third, by lowering the price of bonds and thus raising the effective interest rate that
bonds pay.
 Figure 12.7: The figure shows the Federal Reserve's target for the federal funds rate
from 1982 to 2019.

Question 12.04
Question 12.4
Figure 12.7 shows a history of the target federal funds rate. Use that figure along with
the caption below it to describe, from 1992 to now, whether the Federal Reserve had
the policy to contract or expand the money supply and whether it was likely buying or
selling bonds.

Hover here to see the hint for Question 12.04.

Click here to see the answer to Question 12.04.

FOMC Press Release [1]

The Federal Open Market Committee decided today to lower its target for the federal
funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and
business spending has been subdued and labor markets have softened further.
Financial markets remain under considerable stress, and tight credit conditions and the
deepening housing contraction are likely to weigh on economic growth over the next few
quarters.

—April 30, 2008

Read the full press release on

the US Federal Reserve website.

FOMC Press Release [2]

... In these circumstances, the Federal Reserve will employ all available tools to
promote economic recovery and to preserve price stability. The Committee will maintain
the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate
that economic conditions are likely to warrant exceptionally low levels of the federal
funds rate for an extended period. As previously announced, to provide support to
mortgage lending and housing markets and to improve overall conditions in private
credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency
mortgage-backed securities and up to $200 billion of agency debt by the end of the
year.

—June 24, 2009

Read the full press release on the

US Federal Reserve website.
Notice in FOMC press releases above that the description of monetary policy in April
2008 was one of lowering the target federal funds rate. There was no discussion of
buying bonds. In the 2009 press release, the Fed reiterated their target federal funds
rate of 0 to 0.25 percent but also indicated that it would make substantial purchases of
agency mortgage-backed securities (think of this as a particular kind of bond used to
raise funds for mortgage lenders) as well as additional Treasury securities. To
summarize, the Fed typically communicates changes in monetary policy by announcing
a change in the federal funds rate. But the Fed doesn’t set the federal funds rate.
Instead, the announced change signals that the Fed will be buying bonds if it has
announced a decrease in the federal funds rate, or selling bonds if it has announced an
increase in the federal funds rate.

In the wake of the Great Recession and again during the Covid-19 pandemic, the
Federal Reserve extended its open market operations to achieve more than just a target
federal funds rate. These expansions of the Federal Reserve's goals are discussed in
detail later in the chapter.

12.2.2​Other Tools of Monetary Policy

​The Federal Reserve has three other tools that can be used to achieve changes in the
money supply, although they are typically less important than open market operations.
These other tools are changes in the discount rate, in reserve requirements, and in the
interest the Fed pays on banks’ excess reserve balances.

Changes in the discount rate are often used, but not quite as often as the target federal
funds rate. However, those changes have little real effect on the money supply.
Changing the reserve requirement is a potentially powerful tool, but it is seldom used.
The Fed only began paying interest on excess reserve balances in October 2008. This
interest rate is a new tool, one with which we do not have much experience.
12.2.2.1 The Discount Rate

A change in the discount rate is announced in the last paragraph of the April 2008
FOMC press release referenced above. The Federal Reserve will lend reserves to
banks through what is called the "discount window." Any institution that has deposit
accounts subject to reserve requirements has access to the discount window; this
includes not only commercial banks, but also savings and loans banks and U.S.
branches of foreign banks. The discount rate is the interest rate the Federal Reserve
charges when those institutions borrow reserves through the discount window.

The theory is that the higher the discount rate, the more costly it is to borrow reserves,
and therefore the less likely it is that banks will be fully loaned out (hold no excess
reserves). That is, it is less likely that the money supply will have been expanded to its
absolute maximum.

The Federal Reserve is often described as the lender of last resort. If banks need
reserves and cannot borrow from any other private lender, the Federal Reserve stands
ready to make loans as a last resort. In this manner, the Federal Reserve is theoretically
adding to the security and safety of the banking system. It is always there, and because
it can create reserves, it always has money to lend.

Prior to January 2003, the discount rate was normally slightly below the target federal
funds rate. While there are actually several discount rates, the primary discount rate is
now 1 percent above the target federal funds rate. However, normally when banks
borrow reserves they borrow from other banks rather than directly from the Federal
Reserve. This is particularly true now that the discount rate is above the federal funds
rate.
The Federal Reserve banks recommend changes in the discount rate to the board of
governors, and those changes occur once the board approves those recommendations.
That is what is being announced in that last paragraph of the FOMC press release from
June 2009.

​12.2.2.2 The Required Reserve Ratio

As we discussed in Chapter 11: Money, the Federal Reserve requires institutions having
deposit accounts to hold reserves equal to a fraction of the number of deposits held.
Reserves can be held either as currency in the banks’ vaults or as deposits in accounts
with the Federal Reserve.

Reserve requirements directly affect the money-creating capabilities of banks. Reserve

requirements ensure that banks have funds available to pay out deposit withdrawals,
but they also impose a cost on banks—the opportunity cost of the interest that could be
earned by loaning reserves out. Because of this cost, the Federal Reserve is reluctant
to increase reserve requirements. The Federal Reserve alters required reserve ratios
rarely, making changes in reserve requirements the least frequently used tool of
monetary policy. This is largely because it is so easy to make a mistake with such a
powerful tool; a slight increase can suddenly depress the money supply. The Fed
learned this the hard way with a disastrous increase in 1937. (The most recent change
in the percentages required was in April 1992. The size of deposits at which the
requirements become effective is adjusted annually to maintain a constant real level.
See Table 12.1.)
 Table 12.1: Required
reserve ratios as of May 2019.

Question 12.05
Question 12.5
Explain what would happen as a result of an increase in the required reserve ratio. Be
sure to explain the process from the very beginning all the way through to a new
aggregate demand and aggregate supply equilibrium.

Hover here to see the hint for Question 12.05.

Click here to see the answer to Question 12.05.

12.2.2.3 ​Interest Paid on Required and Excess Reserves

A number of new tools were created during and after the 2007–2009 recession, and
several continue to be used. One important addition is that the Federal Reserve now
pays interest on excess reserves. Interest paid on required reserves was a change
originally designed to reduce an implicit tax on banks. That implicit tax was the forgone
interest banks could earn by lending the funds that the Fed requires them to hold in
reserve. Now banks earn interest on their required reserves—2.35 percent as of May
2019 (see Table 12.2). Thus, the implicit tax on required reserves is smaller now than it
would have been if the Fed paid zero interest.

Table 12.2​​: Interest rates paid on reserves.

​However, the most important part of this change for monetary policy is that the Federal
Reserve can pay interest on excess reserves and can change those interest rates when
appropriate. The following question illustrates why interest paid on excess reserves (as
opposed to the interest rate paid on required reserves) is an important monetary policy
tool.

Question 12.6

Imagine you are running a bank and you are deciding how much of your funds to
deposit with the Fed. Your alternative to depositing funds with the Fed is to lend them to
businesses and individuals. What are you likely to do if the Federal Reserve increases
the interest rate that it pays on your deposits with them?

correct answers are hidden

responses are hidden

Make more loans and reduce reserves at the Fed

B
Increase reserves at the Fed and reduce loans

Increase both loans and deposits at the Fed

Play more golf

​Question 12.07
Question 12.7
Explain how and why the Federal Reserve might use the ability to pay interest on
excess reserves to encourage banks to either contract or expand the number of loans
they might make.

Hover here to see the hint for Question 12.07.

Click here to see the answer to Question 12.07.

Question 12.08
Question 12.8
In your own words, describe how each of the four primary tools of the Fed works.

Hover here to see the hint for Question 12.08.

Click here to see the answer to Question 12.08.

Unemployment Hits 24‑Year Low [3]

Robust job growth fueled by low interest rates and mild winter weather returned the
nation's unemployment rate to a 24‑year low of 4.6 percent in February. The seasonally
adjusted unemployment rate declined from 4.7 percent in January and December and
matched November's 4.6 percent rate, which was the lowest since October 1973, the
Labor Department said today.

—The Associated Press,

March 6, 1998

Read the full article on the Deseret

News website.

Question 12.09
Question 12.9
What does the “Unemployment” article above lead you to expect?

Hover here to see the hint for Question 12.09.

Click here to see the answer to Question 12.09.

Question 12.10
Question 12.10
Given that expectation, what do you think the Federal Reserve might do?

Hover here to see the hint for Question 12.10.

Click here to see the answer to Question 12.10.

Question 12.11
Question 12.11
Given the expected Federal Reserve action, what do you think will happen to bond
prices?

Hover here to see the hint for Question 12.11.

Click here to see the answer to Question 12.11.

Question 12.12
Question 12.12
What would you do now if you own federal securities?

Hover here to see the hint for Question 12.12.

Click here to see the answer to Question 12.12.​

Question 12.13
Question 12.13
What will happen to the price of bonds now? Why?

Hover here to see the hint for Question 12.13.

Click here to see the answer to Question 12.13.

12.3 Monetary Policy in Action

​12.3.1 Monetary Policy in Recessions

We discussed above that the Fed’s objective is to achieve full employment and stable
prices. The FOMC announced in January 2012 that its interpretation of this somewhat
vague objective is to target a 2 percent inflation rate (measured by the index for
personal consumption expenditures). If the economy appears to be headed toward a
recession, the Federal Reserve will see that it is at risk of missing its objective and will
consider using monetary policy to stimulate the economy. The result, if the Federal
Reserve has a goal of returning the economy to full employment, is rising spending.
When the Federal Reserve undertakes an expansionary monetary policy, bank reserves
and the money supply increase, loans are easier to get, the number and amount of
loans increase, and interest rates fall. As loans are easier to get and have lower interest
costs for borrowers, investment spending is likely to increase. An increase in investment
spending will have a multiplied effect on total spending. Real GDP will increase,
unemployment decreases, and there will likely be some increase in prices. This process
is summarized in Figure 12.8.

Figure 12.8:
This chart shows a summary of the impact of open market operations on the economy.
Our graphical model shows the money supply changing, then investment, then total
spending and aggregate demand, and finally a new short-run equilibrium. In Figure 12.9
on the left, the money supply increases and interest rates fall. The graph on the right
shows that at lower interest rates, investment spending increases.

Figure
12.9: Right: At lower interest rates, investment spending increases. Left: When the
money supply increases, interest rates fall.

Figure 12.10 shows total spending increasing and the economy moving to a new higher
equilibrium level. Figure 12.11 puts aggregate demand together with aggregate supply.
Assuming a fall in aggregate demand was the cause of the recession, we are initially at
point A. Successful monetary policy has caused an increase in aggregate demand,
ultimately taking us to point B.
 Figure
12.10: An aggregate expenditures model showing an increase in investment. An
increase in investment leads to a higher equilibrium total output in the economy.

Figure 12.11:
Successful monetary policy during a recession would increase aggregate demand,
bringing the economy from point A to point B.

Question 12.14
Question 12.14
Describe the process illustrated above in words. What is actually happening from the
beginning to the end?

Hover here to see the hint for Question 12.14.

Click here to see the answer to Question 12.14.

Graphing Practice 12.01

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Graphing Practice 12.02

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12.3.2 Monetary Policy during Inflation

​If the Fed sees conditions that will likely lead to higher inflation, it will undertake exactly
the opposite steps. Go through the explanation yourself. Suppose we start at full
employment in a long-run equilibrium. One component of spending increases, taking us
to point B in Figure 12.12. What should the Federal Reserve do? How will it work?
 Figure 12.12:
Aggregate demand increases beyond full employment levels, leading to inflation.

Under inflationary conditions, like those shown in Figure 12.12, aggregate demand is
increasing too rapidly. The Federal Reserve should slow the growth of the money
supply. By selling bonds (or buying fewer bonds), reserves will fall (or grow more
slowly). Banks will be able to make fewer loans. Interest rates will begin to rise since
banks have lower reserves and the prices of bonds fall. The higher interest rates will
cause investment spending to fall. That will cause a multiplied decrease in total
spending. Pressure will be taken off of prices, and employment and output will fall back
to the full employment levels.

As the news clip below shows, the Federal Reserve has recently struggled with inflation
rates that are too low, rather than too high. When inflation is too low, the federal
Reserve is under pressure to lower the target Federal Funds Rate in order to push
inflation closer to the 2 percent target.

A Key Reason the Fed Struggles to Hit 2% Inflation: Uncooperative Prices [4]
Recent studies have shown prices in some sectors--such as housing--do indeed rise
faster when growth is in full swing, unemployment low and markets frothy. But [price
inflation in] a large chunk of the economy, from health care to durable goods, appears
insensitive to rising or falling demand.

The U.S. is now in its longest expansion on record and unemployment is near a
half-century low, yet inflation, at 1.5% in May, remains stuck below the Fed's 2% target.

Fed policymakers fear if consumers and businesses expect such low inflation to persist,
they may adjust their own price and wage-setting behavior accordingly. That could
cause low inflation to become entrenched, a vicious cycle economists call
"Japanification."

"That road is hard to get off of," Fed Chairman Jerome Powell told Congress this month.
"So I think it's quite important that we...fight to keep inflation up to 2% and use our tools
to achieve that."

-Paul Kiernan, The Wall Street Journal, July 28, 2019

Question 12.15
Question 12.15
Describe the appropriate monetary policy to use in a recession caused by a negative
aggregate demand shock. How will it work?

Hover here to see the hint for Question 12.15.

Click here to see the answer to Question 12.15.
12.3.3​Monetary Policy in a Supply Shock
​What about a supply shock? Remember rising oil prices and their effects on aggregate
supply? We go from point A to point B in Figure 12.13: higher prices, lower output, and
higher unemployment.

Figure 12.13:
When a negative supply shock occurs, aggregate supply shifts to the left and the
economy moves from point A to point B.

We could slow the economy down to solve the inflation problem. In this case, we go to
point C in Figure 12.14. The cost is, of course, higher unemployment.
 Figure
12.14: Negative supply shocks result in contractionary monetary policy to fight inflation.
The negative supply shock shifts the AS curve to the left, and contractionary monetary
policy then shifts the AD curve to the left, bringing down price levels.

Or we can use monetary policy to stimulate the economy to solve the unemployment
problem. That would mean an expansion of the money supply and an increase in
spending. We would end up at point D in Figure 12.15. Here the cost is higher inflation
when inflation is already a problem.
 Figure 12.15:
Negative supply shocks result in expansionary monetary policy to reduce
unemployment, yet this policy worsens the inflation problem.

In the case of a supply shock, the policy choices are not good. We face two problems:
rising unemployment and rising inflation. We can solve either problem, but in the
process we make the other problem even worse.

Graphing Practice 12.03

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12.3.4​Why Use Monetary Policy?

In inflationary conditions and in recessions, the economy will eventually return to the full
employment level of output. But how does it work? Think back to our discussion in
Chapter 11: Money. (You should be able to re-create this process. If it is a challenge, go
back to Chapter 11 to review the process.) In inflationary conditions, shown in Figure
12.16, the increase in the demand for labor eventually causes wages to rise, which in
turn causes businesses to increase prices further. Returning to full employment is at the
cost of even more inflation. The use of monetary policy to slow the rise in spending will
prevent that further rise in inflation. The initial changes are from point A to point B. The
natural movement is to go to point C. However, with successful monetary policy, we will
go back to point A.

Figure 12.16:
In inflationary conditions, without monetary policy the economy's natural movement is to
go to point C. Instead of moving to point C, however, successful contractionary
monetary policy would shift the new AD curve back to its original level, returning the
economy from point B to the initial point A.

In the case of a recession, we also know that the economy will return to full
employment. And we know that the process works through the adjustment of wages and
prices. (Again, go back and review this process in Chapter 9: Aggregate Demand,
Aggregate Supply, and a New Equilibrium if you need to.) Wages will eventually begin to
fall, lowering costs and bringing us back to full employment. However, this process
takes time, during which we are suffering from higher rates of unemployment and most
likely political pressure to do something about the situation. The Federal Reserve, in this
case, can stimulate the economy so that instead of staying at point B in Figure 12.17 for
a while, we return more rapidly to full employment.
 Figure 12.17:
In recessionary conditions, monetary policy can fix the high unemployment problem.

In the case of a supply shock, the policy choices are not good. Some would argue that
the “do nothing” approach might be best. The resulting process, much like the recession
above, would be downward pressure on wages (but remember, this time we would have
just gone through a rapid rise in prices), bringing us back to full employment. We would
be reducing inflationary pressures and causing rising output and employment. While this
is a good alternative, it may take a long time for wages to adjust. Such a long period of
high unemployment has significant costs and may not be acceptable politically.

12.3.4.1 Case Study: Monetary Policy in U.S. Recessions, 1985-2008

 Figure 12.18: Federal Funds Target Rates. [4]

As the figure above shows, the Federal Reserve does not take a passive approach to
reductions in GDP. When a recession occurs, the Federal Reserve lowers the target
federal funds rate. During the 1990-1991 recession, the target rate fell from 8 to 6
percent. The 2000 recession brought a reduction in the target rate from 5 to 2 percent,
and the 2007 to 2008 Great Recession brought the target rate as low as 1 percent. In
2008, the Federal reserve stopped announcing a target rate and began announcing a
targeted range of federal funds rates. The target ranges are narrow: 0.25 percentage
points wide. (For example, 2.0 to 2.25 percent.)

12.4​Challenges of Monetary Policy

12.4.1​Timing
​We have discussed the process through which monetary policy works. Figure 12.8
earlier in this chapter demonstrates one brief outline. The process works through money
creation or destruction, an effect on interest rates, and then a change in investment
spending.

When businesses make decisions to invest, they normally go through a process of

evaluating benefits and costs, applying for loans, and lining up builders, suppliers, and
workers. All of that takes time. The Federal Reserve can decide quickly what policy to
undertake. However, once they make that decision, that policy will not begin to work
until spending is affected. There are significant lags in the process.

In addition, the Federal Reserve looks at data that describe what happened last month
or last quarter. And it takes the Federal Reserve a period of multiple observations—not
just one—to discover a trend. So even though the Fed can act quickly, it takes some
time for the data they receive to indicate they ought to take action. All of this together
means that there is a long and unpredictable lag between an event and when the Fed
responds with the appropriate policy. Furthermore, when the Federal Reserve engages
in open market operations, its actions affect spending about nine months from now,
sometimes more and sometimes less. If the forecasts of future economic conditions are
wrong, then the Federal Reserve may end up doing exactly the wrong thing, making a
future problem worse.

The following article illustrates a recent instance in which the Fed updated its forecast of
future economic conditions and announced a change to the stance of monetary policy
as a result.

​Set to Lift Interest Rate, Fed Embraces Investors’ Optimism [5]

"The Federal Reserve is poised to raise its benchmark interest rate in mid-March,
significantly sooner than investors had expected, as it moves to keep pace with a wave
of economic optimism that started with the election of President Trump.

In an unusually clear statement about a pending decision, the Fed chairwoman, Janet L.
Yellen, said on Friday in Chicago that the central bank was likely to act at its next
policy-making meeting—barring any unpleasant economic surprises.
 —Binyamin Appelbaum, New York Times, March
3, 2017

Read the full article here and answer the questions below.

Question 12.30
Question 12.30
Why is the Federal Reserve planning to increase interest rates?

Hover here to see the hint for Question 12.30.

Click here to see the answer to Question 12.30.

Question 12.31
Question 12.31
How does increasing the federal funds rate affect other interest rates? Which ones does
the article mention?

Hover here to see the hint for Question 12.31.

Click here to see the answer to Question 12.31.

Question 12.32
Question 12.32
This article mentions “the Fed’s job.” Is this article consistent with the information in this
chapter?

Hover here to see the hint for Question 12.32.

Click here to see the answer to Question 12.32.

12.4.2​The 2007–2009 Recession

Determination of the December 2007 Peak in Economic Activity [6]

​The Business Cycle Dating Committee of the National Bureau of Economic Research
met by conference call on Friday, November 28, 2008. The committee maintains a
chronology of the beginning and ending dates (months and quarters) of U.S.
recessions. The committee determined that a peak in economic activity occurred in the
U.S. economy in December 2007. The peak marks the end of the expansion that began
in November 2001 and the beginning of a recession. The expansion lasted 73 months;
the previous expansion of the 1990s lasted 120 months.

—The National Bureau of Economic

Research

Read the full report on the NBER

website.

The 2007–2009 recession is typical of most recessions in that the cause was not a
single event, but a number of simultaneous and often overlapping economic changes.
Some were independent of the other contributing factors; some resulted from changes
in other events. Primary among the causes was a tightening of monetary policy from
early 2004 continuing to early 2007, a severe failure of financial markets to work
smoothly, and, as a consequence, a severe reduction in loans to a variety of
businesses.

But that is far from all. Rising oil and food prices led to a small negative supply shock.
Housing and stock prices fell rapidly. And as individuals’ wealth fell, consumption
spending fell.
Housing prices had been rising rapidly in what is now viewed as a housing bubble. The
housing bubble was surely fed by relatively low interest rates from 2001 to 2004. The
later higher interest rates in part broke the bubble, and housing prices started to decline
rapidly. Housing construction slowed. That was a direct effect and a direct contributor to
the slowdown in the economy. Housing makes up a significant portion of most families’
wealth. As wealth fell, consumption spending fell.

At the same time, related to the breaking of the housing bubble, we entered into an
extremely serious, unusual financial crisis. The financial crisis, in turn, had a number of
contributing causes. The primary cause, however, seems to have been that a significant
number of homeowners were defaulting on their mortgage payments because of higher
interest rates and lower house prices.

Many mortgages were put together into financial securities that were then sold to a
number of different financial investors. Those mortgage-backed securities were owned
by banks, insurance companies, investment companies, endowments, and wealthy
individuals. That was not the problem. The challenge to the financial system was that
the mortgages that were failing had been combined with other still-functioning, good
mortgages. The mortgage-backed securities included high-quality and low-quality
mortgages. Government had supported and facilitated the creation of these securities
as another vehicle to promote home ownership since they expanded the number of
funds available to mortgage lenders and therefore home buyers.

But because it was difficult to tell how much of any one security was good or bad, the
value of those securities was difficult to determine. The value of a large number of
similar securities began to decline. Because these made up a large portion of many
financial companies’ investments, it was difficult to determine whether or not many
financial companies were solvent or not. Thus, banks and other financial institutions
became less willing to lend to each other. Loans and financial investments slowed
significantly.

In situations where businesses are unwilling to invest and expand and consumers are
afraid to increase consumption spending, monetary policy faces challenging conditions.
The Fed can expand bank reserves, enabling banks to make loans. The Fed can force
interest rates down so that it is less costly to borrow. However, if businesses and
consumers are concerned more with future economic conditions than they are with the
availability and cost of loans, traditional monetary policy may not function very well.

A classic example is often used to differentiate between restrictive and expansionary

policy. The Fed can pull back on a string to slow expansion in the economy. Holding the
economy back seems to work if the pullback is significant enough. However, pushing on
that string to stimulate an economy may not be nearly as effective. Once interest rates
have reached low levels, there may not be many monetary tools left to stimulate
increased spending and activity in the economy.

Macroeconomists are divided on how effective monetary policy can be at the “zero
lower bound” (when the federal funds rate is near zero). Some prominent
macroeconomists, including former Fed chair Ben Bernanke, have argued forcefully that
monetary policy can still be effective at the zero lower bound. Others are skeptical,
especially given that the recovery from the last recession was very slow even though
the Fed held the federal funds rate below 0.25 percent for seven years.

12.5​New Monetary Policy Tools

​In response to the slowing economy, the Federal Reserve began traditional stimulative
monetary policy in late summer 2007. The target federal funds rate and the discount
rate were lowered. Open market operations were designed to increase reserves and
lower interest rates.
Because of the seriousness and depth of the evolving financial panic and the recession,
and because the target federal funds rate was approaching zero, the Fed initiated a
number of new policies, several of which continue. Most were new ideas with new
names and often confusing acronyms.

Beginning in 2008 and 2009, the Fed purchased the longer-term debt of what are called
government-sponsored enterprises (GSEs) that guarantee mortgages and
mortgage-backed securities. They also purchased mortgage-backed securities from a
variety of insurance companies and financial firms. In addition, the Fed purchased
long-term U.S. government bonds.

Normal open market operations are focused on buying and selling very short-term U.S.
government debt. The new efforts were purchases of other types of debt. Yet all of the
efforts were still designed to lower interest rates and encourage banks and other
lenders to continue to make loans to facilitate spending and investment.

The Fed continued to expand its purchases of bonds even after the target federal funds
rate was lowered to a range of zero to one-quarter of 1 percent. This buying has been
labeled quantitative easing—a term used in connection with Japanese monetary policy
in the early 2000s. A second round continued into 2010 and 2011. Longer-term U.S.
Treasury securities were purchased with the hope of lowering longer-term interest rates.
(In March 2020, the Federal Reserve announced it would return to quantitative easing in
the wake of the Covid-19 pandemic.)

In addition to those efforts, the Fed provided dollar assets to foreign central banks so
that banks and financial institutions abroad would continue to lend dollar deposits
abroad. The Fed also provided a variety of different kinds of other assets for short-term
lending on the part of non-bank financial institutions throughout the financial crisis.
There have been enormous increases in bank reserves as a result of all of these efforts.
Prior to the financial crisis, the number of reserves held at Federal Reserve banks
fluctuated between $8 and $16 billion. In August 2014, banks and other institutions held
$2.8 trillion in reserves at the Fed. With all of those excess reserves, the banking
system has tremendous capacity to expand the money supply if they start to increase
lending. Once the economy stabilized and entered a sustained expansionary period, the
Fed began to reduce the amount of reserves by selling some assets and letting others
mature without purchasing new ones. The Fed has also increased the interest it paid on
excess reserves to slow the expansion of bank lending and slow the growth of the
money supply. The goal was to prevent spending from rising so rapidly that significant
inflation resulted.

12.5.1.1 Case Study: COVID-19 Pandemic

In many ways, the 2007-2009 recession was a practice round for how the Federal
Reserve would attempt to combat the economic downturn caused by the novel
coronavirus known as COVID-19. The virus severely reduced spending by businesses
and consumers, resulting in a massive reduction in output and an unprecedented rise in
unemployment. In March 2020, the Federal Reserve began aggressive action to reduce
the economic consequences of the pandemic.

The central bank’s first move was to lower the target federal funds rate to a target range
of 0.0% to 0.25% in March 2020, meaning the target rate had again reached the zero
lower bound. But the Federal Reserve’s interventions did not end there. The Fed
engaged in asset buying well beyond their standard bond-buying activities.
Mortgage-backed securities (see Section 12.2.1.3), other Treasury securities, and
corporate debt products were part of the Fed’s market interventions in 2020. In all
cases, the Fed’s interventions are more sizable than their interventions during the
financial crisis of 2007-2009. The central bank also began buying bonds issued by
municipalities (cities and counties) above a certain size in order to help these local
governments meet their expenses when much of their tax revenue, particularly sales tax
receipts, had dried up.

And, finally, for the first time in 90 years, the Federal Reserve’s intervention in 2020
included direct lending to small and medium-sized businesses. The Fed’s new Main
Street Lending Program makes loans to appropriately sized businesses that meet
relatively stringent credit requirements. The Fed has not lent money to businesses of
this size since the Great Depression, a sign of just how concerned policymakers are
about the economic impacts of COVID-19.

The Federal Reserve Is Changing What It Means to Be a Central Bank [7]

"By lending widely to businesses, states and cities in its effort to insulate the U.S.
economy from the coronavirus pandemic, it is breaking century-old taboos about who
gets money from the central bank in a crisis, on what terms, and what risks it will take
about getting that money back.

Economists project the central bank’s portfolio of bonds, loans and new programs will
swell to between $8 trillion and $11 trillion from less than $4 trillion last year. In that
range, the portfolio would be twice the size reached after the 2007-09 financial crisis
and nearly half the value of U.S. annual economic output.

It would make its role in the economy far greater than during the Great Depression or
World War II, according to Wall Street Journal calculations.

After cutting interest rates to near zero in mid-March, the Fed began a torrent of
bond-buying programs to stabilize markets. Between March 16 and April 16, it bought
Treasury and mortgage securities at a pace of nearly $79 billion a day. By comparison,
it bought about $85 billion a month between 2012 and 2014."

-Nick Timiraos and Jon Hilsenrath, "The Federal Reserve Is Changing What It Means to
Be a Central Bank," The Wall Street Journal, April 27, 2020.

12.6​Monetarists and the Quantity Theory of Money

Milton Friedman, a Nobel Prize–winning economist, led a group of economists in the

1960s and 1970s in analyses of the importance of changes in the money supply. Those
economists have been labeled the “monetarists because of their emphasis on the
importance of the money supply and monetary policy in our economy. One of the
models they used is a slightly different look at the economy, but a very important one.
Think of the following simple formula, where M is the money supply, V is the number of
times each dollar is spent on final goods and services each year, P is the overall price
level, and Q is real GDP:

PQ is nominal GDP—that is, total spending on final goods and services. MV is the
money supply multiplied by the number of times each dollar is spent each year—that is,
total spending on final goods and services. Thus, they must be equal.

Consider a recent (beginning of 2017) set of data describing the U.S. economy:
This is a tautology—something that is true by definition. It is an accounting identity that
must always hold. Monetarists add a few basic assumptions about how velocity and real
GDP are determined and turn the basic tautology into something much more important.
First, they argue that velocity (V) depends on how much money people hold in relation
to their income. To see this, suppose everyone held half of their annual income as
money (currency and deposits). In other words, GDP (which is the sum of everyone’s
income) times 50 percent would have to be equal to the money supply:

​Rearranging the equation above, we can see that velocity must be 2 in this example:

​The point is that velocity is the inverse if the fraction of income people in the economy
hold as money. So if people decide they want to hold more money as a fraction of their
income, velocity must drop unless something else changes. Back when the theory was
first developed, economists believed that velocity would only change slowly and be
quite predictable.
Second, real GDP (Q in our equation) will tend toward the full employment level of real
GDP regardless of the amount of money that circulates in the economy. That level of
real GDP will, in the long run, tend to grow at a steady pace and is determined by the
growth rates of productivity and resources. This analysis turns the definitional formula
into one that describes the role of the money supply in our economy. It is called the
"quantity theory of money."

The quantity theory says that if V and Q are fixed, changes in M (the money supply) will
have a powerful and predictable effect in the long run. Specifically, changes in M will
only affect price level. (Or in terms of growth rates, the faster the growth of M the higher
will be inflation.) Thus, monetarists argue that in the long run, the cause of inflation is a
money supply that grows too rapidly compared to real GDP growth.

What can we conclude from this analysis? A key assumption in the monetarists' view is
that prices adjust freely. Our experience, though, is that prices do not seem to be
perfectly flexible. Economists often use the term “sticky” to describe their movements.
Contracts are signed. Catalogues are printed. Traditions are maintained. Many prices
are slow to change, particularly to move downward. If prices are sticky, changes in the
money supply may indeed cause short-run fluctuations in real GDP. The conclusion is
that monetary policy may be used to counter short-term fluctuations in spending.
However, if we try to keep unemployment below the full employment level, we will
experience higher rates of inflation.

This video gives an intuitive explanation of the quantity theory of money:

​In the long run, as prices do change and real GDP returns to the potential level, the rate
of growth of the money supply will determine the rate of inflation. If the money supply
growth is faster than the long-run growth in potential real GDP and velocity is not
changing, then we will experience inflation.

​Figure 12.18 shows the result of trying to stimulate the economy to a level of output
greater than the potential level. We begin at point A. The Federal Reserve increases the
money supply, causing an increase in aggregate demand. We go to point B, a short-run
equilibrium. Wages begin to increase, supply decreases, and we begin to head toward
the long-run equilibrium at point C. The money supply is increased again to maintain
output and employment, aggregate demand increases to AD3, and we move to point D.
Once more low unemployment causes wages to increase, and we move toward point E.
The money supply is increased again, and we head toward point F. The process
continues, and in effect we will be moving in a continual upward path from point B to D
to F, and so on. We can achieve a low unemployment rate, but only at the cost of higher
inflation.
 Figure 12.19:
Maintaining very low unemployment can result in inflation.

​Monetarists go beyond providing us with a long-run model of inflation. They argue that
monetary policy is difficult to manage given our forecasting problems, our inability to
measure the money supply accurately, and the potential political bias to stimulate the
economy to unemployment rates lower than the full employment rates. They argue that
it is so powerful and mistakes are so often made that we really should not rely on
discretionary use of monetary policy. Instead, we should use a rule that will allow the
Fed to achieve its long-run goal of full employment and stable prices.

Many macroeconomists argue that central banks should pick a rule that sets the federal
funds rate according to a mathematical formula involving current economic variables
such as inflation and GDP, and then stick to the rule. One such advocate is John Taylor,
and this concept is often referred to as the Taylor Rule. Not all economists, including
many who work for the Federal Reserve, agree with his position. The drawback, they
argue, is that a central bank would tie itself to a strict formula and then be unable to deal
with unexpected shocks when deviating from the rule would be beneficial to the
economy.
Wall Street Moves Main Street [8]

"As the stock market continues its erratic gyrations—with the Dow Jones Industrial
Average dropping 207 points one day last week, only to regain its ground fitfully since
then—anxiety mounts that a profound correction is overdue. In such a situation, it is
important to consider the effect the stock market has on the real economy. Are Wall
Street and Main Street closely linked, or is the stock market simply a gambling parlor
unconnected to real economic activity?