Chapter 14

Monetary Policy and the Federal Reserve System

I. Principles of Money Supply Determination

when we talk about the “nominal money supply,” what is it that

we are really talking about?

how does a nation’s central bank undertake monetary policy

decisions?

A. Three groups affect the Money Supply

1. The Central Bank

responsible for conducting monetary policy

2. Depository Institutions

these are the banks that accept deposits and make loans

3. The Non-Bank Public

people and firms who hold money as currency and coin or as

bank deposits

NOTE: Throughout the semester, we have assumed that the

central bank has perfect control over the nominal money supply.

1
Now we see that this is not true; a central bank cannot directly
control either the actions of depository institutions or the actions
of the non-banking public.

B. The Money Supply in an All-Currency Economy

this is one extreme where there is no banking system

all currency in the economy is held by the public

so DEP = 0

1. Since a barter system is inefficient, most economies create a

central bank to print a uniform money

the central bank uses the currency it prints to buy real assets
from the public

the public accepts this paper currency, and that is how it is

introduced into circulation

but the public will accept this paper currency only as long it
believes that other people will accept it in exchange

the government decrees that its paper currency is “legal

tender”—this means it can be used to pay off private debts and
to pay taxes owed the government

assets of a central bank → the real assets purchased from the

public

2
liabilities of a central bank → the paper currency it has issued
(the currency is an I.O.U. that must be re-paid in the future)

2. The “monetary base” [BASE] is defined as the liabilities of

the central bank that are usable as a money

recall the M1 nominal money supply is defined as currency

[CU] plus banking deposits [DEP]

using this definition, the liabilities of a central bank are

(1) currency held by the non-banking public and by banks [CU]

(2) deposits held on reserve on behalf of member banks [RES]

so, in general, we define BASE = CU + RES

the base is also called “high-powered money” for reasons that

will become clear shortly

3. So, in an economy that uses only currency—and has no bank

deposits—the M1 nominal money supply equals the monetary
base

MS = BASE

C. The Money Supply in a “Fractional-Reserve” Economy

this is the other extreme, where the public holds no currency and
keeps all money as bank deposits

3
so CU = 0

1. The currency that banks hold for the public is called “bank
reserves”

bank reserves are very liquid assets

bank reserves can either be held as “vault cash” or as deposits at

their regional Federal Reserve branch

2. Rather than holding 100 percent reserves that earn no interest,

banks can lend out some of their reserves

(if a bank does decide to keep 100 percent reserves, so that RES
= DEP, this is called “100 percent reserve banking”)

EXAMPLE: The Simple Money Multiplier and the Money

Creation Process

suppose a bank maintains a “required reserve ratio” or “reserve-

deposit ratio” of res = 10 percent

this means a bank needs to keep only 10 percent of the amount

of its deposits on reserve to meet the demand for funds

it is common for banks to lend out some of their deposits, and

only keep a fraction of reserves to meet the need for outflows

now suppose a client deposits $ 100 into his checking account

[DEP]

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ROUND 1: checking account balances ↑ $ 100; banking
required reserves ↑ $ 10; banking excess reserves ↑ $90

ROUND 2: the bank loans out $ 90, so checking account

balances ↑ $ 90; required reserves ↑ $ 9; excess reserves ↑ $ 81

ROUND 3: the bank loans out $ 81, so checking account

balances ↑ $ 81; required reserves ↑ $ 8.10; excess reserves ↑ $
72.90

...

ROUND n: total deposits ↑ by $ 1000

Δ DEP = [1 / res] * Δ RES

→ [1 / 0.10] * $ 100

→ $ 1000

How do we know that this is the equation for the final change in
deposits?

We derive the mathematical solution to this problem using the

fact that a geometric series of the form [a + ax + ax2 + ax3 + …
+ ax n – 1 + … + ∞ = Σ ax n – 1 ] converges to the sum [= a / (1 –
x)] when ‖ x ‖ < 1.

In this example we have:

Δ DEP = 100 [1 + 0.9 + 0.92 + 0.93 + … + 0.9∞]

5
→ 100 [1 / (1 – 0.9)]

→ 100 [1 / 0.10]

*note we now have [1 / res]*

→ 100 [10]

Δ DEP = $ 1000

the initial $ 100 deposit finally ends up as $ 1000 deposits total

the fraction [ 1 / res] is called the “Simple Money (or Deposit)

Multiplier”

it is the “simple” multiplier because in this economy we only

have deposits, no currency

the money multiplier is the ratio of the nominal money supply

(MS) to the monetary base [BASE]

3. When the reserve-deposit ratio is less than 100 percent, the

system is called “fractional reserve banking”

4. The textbook calls this multiplier process the “multiple

expansion of loans and deposits”

5. The multiplier process stops when the banks’ required reserve

holdings are exactly 10 percent of their total deposits, with loans
equal to 90 percent of total deposits
6
remember from Principles class that if a bank chooses to hold
more reserves than required, these are called “excess reserves”

Excess Reserves = Total Reserves – Required Reserves

we generally make two assumptions about excess reserves:

(1) banks get rid of all excess reserves because they are costly to
hold; so excess reserves = 0

(2) households do not hold any currency; if they did, the money
multiplier would die out quickly

6. The money supply in this type of economy is equal to the total

amount of bank deposits

so in this example, MS = DEP = $ 1000

this is because M1 = CU + DEP, and CU = 0 in this economy

7. The relationship between the monetary base and the money

supply is:

STEP I: Since the public holds no currency, MS = DEP

STEP II: Banks hold reserves equal to (res * DEP) which must
equal the currency distributed by the central bank

(res * DEP) = BASE

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STEP III: Solve for DEP and substitute

MS = DEP = (BASE / res)

8. In an economy with fractional reserve banking and no

holdings of currency, the nominal money supply is equal to the
monetary base divided by the reserve-deposit ratio

therefore, each unit of the monetary base allows [1 / res] of

money supply to be created

this is why the monetary base is called “high-powered money”:

each unit of the base issued leads to the creation of more money

D. Bank Runs

1. Banks assume they will never have to pay out more than the
amount of their required reserve holdings

2. If more people than expected want to withdraw funds from

the bank, and the bank does not have enough excess reserves,
then the bank is short

the situation of unexpected demand for bank reserves is called a

“bank run”

3. To remedy this, banks participate in the “federal funds

market”

in the federal funds market, banks buy the required reserves they
are short, and other banks sell the excess reserves they are long
8
this is one contributing factor to the “credit freeze” of 2008:
banks no longer trusted each other and preferred to hold on to
excess reserves rather than risk lending them out

4. If the general population panics and rushes to withdraw its

money—so that several banks all experience runs at the same
time—this is called a “banking panic”

5. During the Great Depression, the FDIC was created in 1933

to prevent bank runs

the FDIC insures bank deposits and essentially provides peace

of mind

depositors know their funds are safe, and there is no need to

withdraw their money

E. The Money Supply in an Economy with both Public

Holdings of Currency and Fractional-Reserve Banking

this is the realistic scenario

in this section we demonstrate why the central bank cannot

perfectly control the nominal money supply

what is the relationship between the money supply and the

monetary base?

1. First, let’s define our terms

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MS = the nominal money supply (M1)

BASE = the monetary base (liabilities of the central bank;

directly controlled by the central bank; the sum of bank reserves
plus currency held by the public)

DEP = bank deposits (checking account balances and traveler’s

checks)

RES = bank reserves (either vault cash or held by regional Fed

branches; the amount of excess reserves is determined by banks)

CU = currency held by non-bank public

res = (RES / DEP) = banks’ reserve-deposit ratio (required

reserves and excess reserves)

cu = (CU / DEP) = public’s desired currency-deposit ratio

2. In this economy, the money supply consists of currency held

by the public and bank deposits, so

MS = CU + DEP

3. The monetary base is held as currency by the public and as

reserves by banks, so

BASE = CU + RES

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4. To find the relationship between these two variables, we
algebraically manipulate the two equations

(i) divide the MS equation by the BASE equation

(MS / BASE) = (CU + DEP) / (CU + RES)

(ii) divide the numerator and denominator of the RHS by “DEP”

(MS / BASE) = [(CU / DEP) + (DEP / DEP)] / [(CU / DEP) +

(RES / DEP)]

(iii) substitute (DEP / DEP) = 1; (CU / DEP) = cu; (RES / DEP)

= res; move “BASE” to the RHS

MS = [(cu + 1) / (cu + res)] * BASE

(iv) if RES is broken into required reserves and excess reserves

MS = [(cu + 1) / (cu + rr + er)] * BASE

where

rr = (required reserves / total deposits)

er = (excess reserves / total deposits)

cu = (currency / total deposits)

res = (total reserves / total deposits)

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NOTE: As mentioned above, we usually assume er = 0, so this
term disappears from the denominator. While this has been true
historically, it no longer strictly applies. In the aftermath of the
Great Recession, banks now hold substantially higher levels of
excess reserves than they did prior to 2008.

5. The fraction [(cu + 1) / (cu + res)] is called the money

multiplier

the currency-deposit ratio (cu) is determined by the public

the reserve-deposit ratio (res) is determined by banks

NOTE: If res is split between excess reserves (er) and required

reserves (rr), then the central bank directly controls the required
reserve ratio, but banks get to decide how many excess reserves
to hold.

in this type of economy, then, the nominal money supply (MS)

equals the monetary base [BASE] times the money multiplier

and here we see that even though the central bank can directly
control the monetary base, because of the money multiplier it
cannot directly control the actual money supply in this type of
economy

(1) the money multiplier is greater than 1 whenever (res < 1)

this is always the case under fractional reserve banking

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(2) when cu = 0, the multiplier becomes [1 / res], the simple
money multiplier from before when all money is held as
deposits

(3) if cu ↑ or res ↑, then the money multiplier ↓

this is an important relationship, because if BASE remains

constant, then the nominal money supply will fall together with
the multiplier

F. Open-Market Operations

1. The most direct and frequently used way of changing the

money supply is by raising or lowering the monetary base
through open-market operations

(1) “open-market purchase”: the central bank prints money and

uses it to buy real assets in the open (public) market → the
monetary base ↑

banks now have a higher reserve-deposit ratio than desired

as banks loan out excess reserves, this begins the multiple

expansion of loans and deposits

this is how an open-market purchase “increases the money

supply”

(2) “open-market sale”: the central bank sells assets in the

market and retires the currency it receives → the monetary base
↓
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G. The money multiplier during severe financial crises

1. What happened during the Great Depression?

the money multiplier fell drastically

the decline was caused by several reasons which each affected

the multiplier

(1) people became mistrustful of banks → they increased the

currency-deposit ratio → multiplier ↓

(2) banks held more reserves in anticipation of bank runs → this

raised the reserve-deposit ratio → multiplier ↓

(3) the Federal Reserve ↑ rr which was a horrible decision! the

Fed was less than 20 years old and very inexperienced; it felt
that ↑ rr would make banks more sound and, in addition, give
the public more confidence

even though the monetary base grew by 20 percent (March 1930

- March 1933), the nominal money supply fell 35 percent

this is why many economists argue that the Federal Reserve

used “pro-cyclical” policy instead of “counter-cyclical”

2. What happened during the Great Recession?

like before, the money multiplier fell drastically

14
but this time, it fell because res ↑

cu was relatively stable because of FDIC insurance

one reason banks held more excess reserves (↑ res) is that the
Fed implemented a new policy: paying interest on reserves

so what is different? the money multiplier fell, but the money

supply increased

why? because the Fed significantly increased the monetary base

by more than the decline in the money multiplier

SHOW SLIDES

Lesson Learned: The Federal Reserve is ↑ % Δ BASE > ↓ % Δ

Multiplier → ↑ % Δ M1. This is in order to avoid repeating
what happened during the Great Depression. Thank goodness
Professor Bernanke was paying attention in his macro class!

II. Monetary Control in the United States

A. The Federal Reserve System

this is the central bank of the United States

1. History

the First Bank of the United States (1791) failed due to public
fears of centralized government power

15
the Second Bank of the United States failed on September 10,
1816, when President Andrew Jackson let its charter expire (this
was for political reasons: he and Nicholas Biddle, the Bank’s
President, hated each other)

the Federal Reserve System is the United States’s third attempt

at a central bank

it was created by an Act of Congress: the Federal Reserve Act

of 1913

the Fed began operating in 1914

when created, the Federal Reserve was given a Dual Mandate

by Congress (the “Goals” of the Federal Reserve System)

(1) the real mandate (achieve full-employment; promote stable

long-run economic growth)

(2) the nominal mandate (maintain price stability and low

inflation)

later, a third mandate was added

(3) serve as the Lender of Last Resort

ironically, the Federal Reserve was created with the purpose of

eliminating severe financial crises in the United States!

2. Locations

16
the Federal Reserve System is divided into twelve geographic
regions

Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta,

Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San
Francisco

which state has two Federal Reserve branches?

Missouri! there is a Fed in Kansas City, and another in St. Louis

(this was the result of a political compromise)

the regional branches are owned by private banks within each

district

a Board of Governors is located in Washington, DC

3. Responsibilities

clear checks between banks

supply currency to banks

supervise, regulate, and audit member banks

each regional branch has a “specialty”

St. Louis Fed: data collection for the monetary aggregates M1

and M2

San Francisco Fed: studies Asian economies

17
New York Fed: conducts open-market operations and bond
trading

4. Differences

the regional branches differ in their macroeconomic

philosophies

Minneapolis Fed and Richmond Fed have mostly classical

economists

St. Louis Fed is the leader in monetarism

New York Fed and Boston Fed lean much more toward
Keynesian views

5. Checks and Balances

(1) the Board of Governors

seven governors are appointed by the President of the United

States

each governor serves a fourteen-year term

the Board of Governors is headed by a chairman

the Chairman of the Board of Governors is appointed by the

President, confirmed by the Senate, and serves a term of four

18
years (which always expires mid-way through a U.S. President’s
term—far from election day)

(2) the Fed is completely self-financed, so not reliant on

Congress for funding

(3) but...since the Fed was created by Congress, it can also be

disbanded by Congress

6. U.S. monetary policy is decided by the Federal Open Market

Committee (FOMC)

all seven governors plus five of the regional Fed presidents on a

rotating basis

the New York president is always on the committee

the FOMC meets eight times a year

decisions about monetary policy are the responsibility of the

FOMC

B. The Policy Tools of the Federal Reserve System

recall: the monetary base is equal to banks’ reserves (vault cash

plus deposits at the Fed) plus currency held by the non-bank
public

policy “tools” are means through which the Fed can manipulate
the monetary base and/or the money supply

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1. Open-Market Operations

this is the primary policy tool used by the Fed

open-market operations are the most direct and most effective

way of changing MS

it is a highly accurate means of controlling the monetary base

at each meeting, the FOMC votes on three options:

(1) option A: ease policy (lower fed funds rate by ½ percentage

point)

(2) option B: maintain current policy stance (keep fed funds rate
at its current level)

(3) option C: tighten policy (raise fed funds rate by ½ percentage

point)

2. Reserve Requirements

the Fed sets the minimum fraction of each type of deposit that a
bank must hold as reserves

an increase in the required reserve ratio (↑ rr) forces banks to

hold more required reserves, thus reducing the money multiplier

this is a very powerful tool, and it is rarely ever used (only in the
event of a structural change in the banking system)

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3. Discount Window Lending

the Fed lends reserves to banks so they can meet depositors’

demands or reserve requirements

the interest rate on such borrowing is called the “discount rate”

the Fed uses the discount window to fill its role as Lender of
Last Resort

increases in the discount rate discourage borrowing and reduce

the monetary base

the Fed modified discount window policy in 2003 (went from

being a negative stigma to no stigma at all)

before 2003, the Fed strongly discouraged banks from

borrowing from the discount window

even though the Fed is now more friendly about discount

lending, the Fed still prefers that banks borrow from each other
in the federal funds market rather than borrowing from the
discount window if that bank needs extra reserves

NOTE: The “federal funds rate” is a market rate of interest—it

is determined by the supply and demand of bank reserves. But
the discount window rate is not based on market forces, it is set
directly by the Fed.

the new policy is broken up like this:

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(1) banks in good condition: they can take out a “primary credit
discount loan”

no questions asked

they pay the “primary credit discount rate”

(2) banks not in good condition: they can take out a “secondary
credit discount loan”

they pay a higher interest rate

they are carefully supervised (audited) by the Fed

4. Quantitative Easing (QE)

technically called “Monetary Policy at the Zero Bound”

this is a rare policy tool the Fed learned from Japan’s liquidity
trap of the 1990s

John M. Keynes hypothesized that a liquidity trap would form if

monetary policymakers become unable to reduce the nominal
interest rate to stimulate the economy because the interest rate is
already at its lower bound of zero percent

QE can only be used when the usual nominal interest rate target
is already at—or is very close to—the zero interest rate lower
bound

22
or, in more colorful language, when the Fed’s primary policy
tools are impotent

in order to fight deflationary pressure, and to inject even more

liquidity into the financial system, the central bank reduces the
amount of Treasury securities it buys

rather than performing traditional open-market purchases, the

central bank starts buying long-term, riskier assets to add to its
balance sheet (federal agency debt, gold, loans to banks, foreign
exchange currencies)

and yes, even toxic assets like mortgage-backed securities

there are three different ways to implement a policy of QE:

(1) the central bank can increase the amount of assets on its
balance sheet by printing significant amounts of (new) money
and buying securities in the open market

(2) the central bank can begin purchasing assets other than short-
term government bonds

(3) the central bank can undergo a public relations campaign to

convince people that the targeted nominal interest rate will stay
low for a very long time (this is to help stimulate C and I)

in the United States since 2008, Ben Bernanke’s Fed is using all
three methods simultaneously

23
it’s still too early for us to see if this aggressive attempt at QE
policy was successful at reducing the severity of the Great
Recession

5. Other

(1) paying interest on reserves

this is a new tool that evolved from the financial crisis in 2008

the Fed now pays interest to banks on their reserves held on

deposit at the Fed

the interest rate paid on reserves is a new tool that the Fed can
use to affect the amount of reserves that banks hold (and thus
affect the money supply)

(2) setting margin requirements on stock purchases (currently

there is a 50 percent margin requirement)

(3) the Fed can impose credit controls on credit cards and
consumer loans

C. The Intermediate Targets of the Federal Reserve System

intermediate policy targets are used by the Fed to guide policy

as a step between its tools—which it can directly control—and
its goals (the Dual Mandate) of price stability and stable
economic growth—that it cannot directly control

24
1. Intermediate targets, therefore, are variables the Fed cannot
directly control but that it can influence predictably

targets are closely related to the Fed’s goals

2. Most frequently used are the monetary aggregates (like M1

and M2) and short-term interest rates (like the fed funds rate)

the Fed uses intermediate policy targets such as the nominal

money supply or short-term interest rates to help guide monetary
policy

3. The Fed must choose only one target! The Fed cannot target
both the money supply and the fed funds rate simultaneously

why?

suppose that both the money supply and the fed funds rate were
too high (above target)

to fix this, the Fed must lower both targets

if the Fed ↓ MS → shifts LM curve up and to the left → the fed

funds rate increases in the money market (instead of going
down!)

to show this graphically:

25
the Fed can either set a target of MS = $ 900b or a target of r = 5
percent, but it cannot have both because then the money market
would not be in equilibrium

4. Inflation Targeting

beginning in 1989, several countries have adopted a system of

targeting the inflation rate, rather than targeting either the
amount of money supply or the level of interest rates

New Zealand (the first), Canada, the U.K., Sweden, Australia,

Spain, Israel, Brazil

even the European Central Bank has adopted a (modified)

inflation-targeting rule

inflation targeting operates by having the central bank publicly

announce its target for the inflation rate (working with the
Executive Branch of government) over the next 1 to 4 years

the current Chair of the Board of Governors, Ben S. Bernanke,

publicly supported inflation targeting before becoming Fed
chairman

although records show the Fed seriously discussed inflation

targeting, the Board ultimately decided not to adopt it
26
but even though the Fed doesn’t explicitly follow an inflation-
targeting policy, it does send strategic, implicit signals to the
public (providing several forecasts to the public; publishing
reports that are in great detail; holding public news conferences;
announcing long-run forecasts for inflation)

5. What if the Fed targets the nominal money supply?

in this scenario, we use Fisher’s quantity theory of money to

explain how the M1 money supply can be used as an
intermediate target

recall from Chapter 7, the quantity equation in percent change

form is:

%ΔM+%ΔV=%ΔP+%ΔY

notice that the LHS variables represent the Fed’s intermediate

targets, and the RHS variables represent the Fed’s policy goals

look at each component

(1) % Δ V = 0 if velocity is constant

(2) % Δ P = inflation; this is the “nominal mandate” of the

Federal Reserve

(3) % Δ Y = economic growth; this is the “real mandate” of the

Federal Reserve

27
let’s assume that π = 2 % and growth = 3 % (their theoretically
“optimal” levels)

so that implies the Federal Reserve should allow the M1 money

target grow at 5 % per year

you might recognize this as Milton Friedman’s Monetarist Rule

philosophy

specifically, he advocated that the Fed should choose a specific

monetary aggregate (such as M1 or M2) and commit itself to
making that aggregate grow at a fixed percentage rate every year
(5 percent!)

if they did this, then the Fed is forced to give up all discretionary
policy

Friedman advocated a “constant money growth rule” since the

money supply is controllable by the Fed and the Fed would no
longer be able to follow destabilizing monetary policies

EXAMPLE: The relationship between velocity, inflation,

and money growth

Assume that the quantity theory of money (from Chapter 7)

holds. Let the velocity of money equal 6; the full-employment
level of output equal 12 000; and, the general price level equal 2.

(i) Find both real money demand and nominal money demand.

28
According to the quantity theory, (MD / P) = (Y / V), where (MD /
P) is real money demand. So, the real demand for money is
given by

(MD / P) = 12 000 / 6 = 2000.

The nominal quantity of money equals real money demand

times the price level. So, nominal demand is given by

MD = 2 * 2000 = 4000.

(ii) Suppose that the Federal Reserve sets the nominal money
supply at 6000. Using the quantity equation, what is the new
price level? Suppose now the money supply increases to 8000.
What is the new price level?

Rearrange the quantity equation:

(MS / P) = (Y / V).

Substitute values for MS, V, and Y:

6000 / P = 12,000 / 6

P = 6000 / 2000 = 3.

Now, if the money supply increases to 8000, we have

8000 / P = 12,000 / 6

P = 8000 / 2000 = 4.
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(iii) Suppose the quantity theory of money holds. If the growth
rate of real GDP is 3 percent per year, and the growth rate of the
nominal money supply is 10 percent per year, what is the rate of
inflation in this economy?

Transform (MS / P) = (Y / V) into its growth rate form:

(Δ MS / MS) – (Δ P / P) = (Δ Y / Y) – (Δ V / V).

Substitute the given growth rates

0.10 – (Δ P / P) = 0.03 – 0.00

(Δ P / P) = 0.10 – 0.03

= 0.07

So the inflation rate is 7 percent.

6. What if the Fed targets the short-term interest rate?

this is, in fact, the variable the Fed has targeted since the late
1980s

if the Fed picks a target range for the nominal (or real) interest
rate, then it manipulates the nominal money supply to hit the
target

the Fed follows this strategy when the main shocks in the
economy are “nominal” shocks
30
this means shocks to the LM curve via either the money supply
curve or money demand curve

by “accommodating” these shocks, the Fed will adjust the

monetary base in order to move the LM curve back to its
original (long-run) position

if the Fed implements this strategy correctly, it should stabilize

output, the real interest rate, and the price level

however, if the shocks to the system primarily affect the IS

curve (changes in Cd, Id, G, NX, Sd), then targeting the interest
rate might be destabilizing

why? because the Fed will have to continually change its target
for the Fed funds rate

a common policy used by the Fed to determine the “optimal”

short-term interest rate is to apply the Taylor Rule (see below)

D. Making monetary policy in practice

1. The IS-LM model makes monetary policy look easy—just

change the money supply to move the economy to the best point
possible

2. But there are two serious problems in practice

(1) lags in the effects of monetary policy

31
while interest rates can change quickly, output (GDP) and
inflation barely respond during the first four months after the
change in money growth

because of these long lags, policy must be based on forecasts of

the future (which are usually wrong)

(2) the channels of monetary policy transmission

the “interest rate channel,” the “exchange rate channel,” and the
“credit channel”

to be completely honest, economists don’t really understand

how monetary policy actually affects economic activity and
prices

E. Examining the financial crisis of 2008

the housing crisis, which began in 2007, led to losses at financial

institutions

initially no one thought it would lead to a major financial crisis

banks began to gradually reduce credit availability because of

worries that some financial institutions were no longer viable

too many banks were lying about their losses (and their
holdings) on mortgage-backed securities

in response, the Fed made credit available through special

lending facilities
32
up to this point, nothing too out of the ordinary was happening
—just a normal business cycle

then, on September 7, 2008, all hell broke loose

within the span of two weeks, Fannie Mae, Freddie Mac,

Lehman Brothers, and AIG all went bankrupt and required
massive government loans

there was a financial panic at the worldwide level

the result of this was that the IS curve kept shifting down and to
the left—again and again and again

in response, the Federal Reserve undertook a massively

expansionary monetary policy to keep lowering the interest rate
lower and lower in order to stimulate the economy

eventually, the United States economy reached a point where the

IS curve was intersecting the flat part of the LM curve—a
liquidity trap!

as a last resort, the Federal Reserve implemented a policy of

quantitative easing

F. The Taylor rule

1. In 1993, John Taylor of Stanford University introduced a rule

that allows the Fed to take economic conditions into account

33
this makes the “rules” of the central bank slightly more flexible
by allowing the central bank to respond to actual economic
conditions

2. The rule is i = π + 0.02 + 0.5y + 0.5 (π − 0.02)

where

i ≡ the nominal federal funds rate

π ≡ the inflation rate averaged over the previous four quarters

y = [(Y - Y ) / Y ] ≡ the output gap: the percentage deviation of

output from its full-employment level

so the real fed funds rate is a function of y and π – 0.02 (the

difference between inflation and the Fed’s two percent goal)

3. If either y or π increases, the real fed funds rate ↑, so

monetary policy should tighten

so far, the Taylor rule seems to be a very good approximation of

how the Fed actually does implement monetary policy!

34