In the short run, the interest rate is determined in the money market and the loanable funds market adjusts in response to changes in the money market. However, in the long run, the interest rate is determined by matching supply and demand of loanable funds that arise when real GDP equals potential output.
The Federal Reserve can use changes in the money supply to change the interest rate. An increase in the money supply drives the interest rate down, and a decrease in the money supply drives the interest rate up. So, by adjusting the money supply up or down, the Fed can set the interest rate.
The Federal Open Market Committee meets every six weeks to decide on the interest rate by targeting a target federal funds rate, which is a desired level for the federal funds rate. This target is then enforced by the Open Market Desk of the Federal Reserve Bank of New York, which adjusts the money supply through open-market operations. Open market operations are purchase or sale of Treasury bills on the open market.
The Fed purchases or sells Treasury bills until the actual federal funds rate equals the target rate. The other tools of monetary policy, lending through the discount window or changes in the reserve requirements, are not used regularly.
Monetary policy, as with fiscal policy, can be used to stabilize the economy. Monetary policy shifts the aggregate demand curve through the effect of monetary policy on the interest rate.
When the Fed expands the money supply, this leads to a lower interest rate. A lower interest rate leads to more investment spending, which leads to a higher real GDP, which leads to higher consumer spending, and so on through the multiplier process. The total quantity of goods and services demanded at any given aggregate price level rises when the quantity of money increases, and the AD curve shifts to the right. This is called expansionary monetary policy.
When the Fed contracts the money supply, this leads to a higher interest rate. A lower interest rate leads to lower investment spending, which leads to a lower real GDP, which leads to lower consumer spending, and so on. The total quantity of goods and services demanded falls when the money supply is reduced, and the AD curve shifts to the left. This is called contractionary monetary policy.
Policy makers try to fight recessions; they also try to ensure price stability, with low (but not zero) inflation. In general, central banks engage in expansionary monetary policy when the actual GDP is below potential output. The output gap is the percentage difference between actual real GDP and potential output; it is positive when actual real GDP exceeds potential output, and negative when actual real GDP lies below potential output.
The Fed has tended to raise interest rates when the output gap is rising (inflationary gap) and cut rates when the output gap is falling (recessionary gap). One exception was in the late 1990s when the Fed left rates steady for several years even as a positive output gap developed, which went along with a low unemployment rate. This was because the inflation rate was low. Low inflation during the mid-1990s helped encourage loose monetary policy both in late 1990s and in 2002-2003.
In 1993, Stanford economist John Taylor suggested that monetary policy should follow a rule that takes into account concerns about both the business cycle and inflation. The Taylor Rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap.
Taylor suggested that the actual monetary policy often looks as if the Fed was following this rule. The rule Taylor suggested was: Federal Funds Rate =1 + (1.5 * inflation rate) + (0.5 * output gap) Taylor’s rule does a pretty good job at predicting the Fed’s actual behavior.
However, in 2009, a combination of low inflation and a large and negative output gap put Taylor’s rule of prediction of the federal funds rate into the negative numbers, which is impossible to target. The Fed responded by cutting rates aggressively and the federal funds rate fell to almost zero.
Monetary policy, rather then fiscal policy, is the main tool of stabilization policy. Like fiscal policy, it is subject to lags: it may take time for the Fed to recognize economic problems and time for monetary policy to affect the economy. However, the Fed can move more quickly than Congress, so monetary policy is the preferred tool.
The Fed tries to keep inflation low, but positive. Although the Fed does not target any specific rate of inflation, it is widely believed to prefer inflation at about 2% per year. However, other central banks do have explicit inflation targets, so they don’t use any rule to set monetary policy. Instead, they announce the inflation rate that they want to achieve (the inflation target), and set policy in an attempt to hit that target; this is called inflation targeting.
The central bank of New Zealand was the first to adopt inflation targeting, for a range between 1-3%. Central banks with a target range for inflation seem to aim for the middle of a range between 1-3%, and central banks with a fixed target tend to give themselves considerable wiggle room.
The difference between inflation targeting and the Taylor rule is that inflation targeting is forward-looking and the Talylor rul is backward-looking. The Taylor rule adjusts monetary policy in response to past inflation, but inflation targeting is based on a forecast of future inflation.
Inflation targeting has two key advantages:1. Transparency: the public knows the objective of an inflation-targeting central bank.2. Accountability: the success of a central bank can be judged by seeing how closely actual inflation rates have matched the inflation target, so central bankers are accountable.
Inflation-targeting is criticized as being too restrictive; there are times when other concerns should take priority over any particular inflation rate, when the stability of the financial system is at risk. For example, in 2007-8 the Fed cut rates more than either the Taylor rule or inflation targeting would dictate because of the fear of turmoil in the financial markets leading to a major recession (which it did).