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58965_13_ch13_p237-258 11/14/08 2:38 PM Page 252


The Core of Macroeconomic Theory




Federal Reserve Behavior in 2008

The U.S. economy was in serious trouble in 2008. The problem began in the housing and mortgage markets. In 2003–2005, housing prices rose rapidly in what some called a housing “bubble.” Banks issued mortgages to some people with poor credit ratings, so-called “sub-prime borrowers,” and encouraged other people to take out mortgages they could not necessarily afford. There was very little regulation of these activities and investors took on

huge risks. When housing prices began to fall in late 2005 and continued into 2008, the stage was set for a worldwide financial crisis. The Federal Reserve responded to the events in 2008 in a number of ways. As we described in Chapter 10, p. 193, in March 2008 the Fed began lending to financial institutions other than commercial banks and guaranteed $30 billion of Bear Stearns’ liabilities to JPMorgan. No longer was the Fed just a lender of last resort. On September 7, 2008, the Fed participated in a government takeover of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), who at that point owned or guar- anteed about half of the $12 trillion mortgage market in the United States. On September 17, the Fed loaned $85 billion to the American International Group (AIG) insurance company to help it avoid bankruptcy. In mid September, the Fed urged Congress to pass a $700 billion bailout bill, which was signed into law on October 3. The Fed also rapidly lowered interest rates in 2008. On January 22, 2008, it lowered the tar- get value of the interest rate that it directly controls, the “federal funds rate,” from 4.25 percent to 3.50 percent. The Fed then lowered the rate further to 3.00 percent on January 30. On March 18, the rate was lowered to 2.25 percent, and by October 29, the rate was down to 1.00 percent. Why did the Fed take these actions? We know from the text that the Fed is concerned about both inflation and output. Inflation was a concern in early 2008 because of rising food and commodity prices, particularly oil prices. (See the Economics in Practice box on p. 255.) But output was more of a concern. The fall in housing prices led to a fall in housing investment. (See the Economics in Practice box on p. 305.) By 2008, there was growing concern that prob- lems in the housing market would spill into other markets and lead to a serious contraction in output. The Fed responded by lowering interest rates. What about the other moves the Fed made in 2008? These nontraditional moves were designed to deal with the fact that many large financial institutions had bet on rising housing prices and lost. While the Fed tried in 2008 to alleviate the crisis, critics say it bears some of the blame for the crisis by its lax regulations and oversight in 2003–2005.

crisis by its lax regulations and oversight in 2003–2005. The opposite is true in times of
crisis by its lax regulations and oversight in 2003–2005. The opposite is true in times of

The opposite is true in times of high output and high inflation. In this situation, the econ- omy is producing on the relatively steep portion of the AS curve (Figure 13.12), and the Fed can increase the interest rate (and thus decrease the money supply) with little effect on output. The contractionary monetary policy will shift the AD curve to the left, which will lead to a fall in the price level and little effect on output. 3 The Fed is likely to increase the interest rate (and thus decrease the money supply) during times of high output and high inflation. In this discussion, we see again the role of the shape of AS curve in determining the likely effect of government policy. Stagflation is a more difficult problem to solve. If the Fed lowers the interest rate, output will rise, but so will the inflation rate (which is already too high). If the Fed increases the interest rate, the inflation rate will fall, but so will output (which is already too low). (You should be able to draw AS/AD diagrams to see why this is true.) The Fed is faced with a trade-off. In this case, the Fed’s decisions depend on how it weights output relative to inflation. If it dislikes high inflation

3 In practice, the price level rarely falls. What the Fed actually achieves in this case is a decrease in the rate of inflation—that is, in the percentage change in the price level—not a decrease in the price level itself. The discussion here is sliding over the distinc- tion between the price level and the rate of inflation. This distinction is discussed further in the next chapter.

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The Core of Macroeconomic Theory


[Related to the Economics in Practice on p. 243] The Economics in Practice describes the simple Keynesian aggregate supply curve as one in which there is a maximum level of output given the constraints of a fixed capital stock and a fixed supply of labor. The presumption is that increases in demand when firms are operating below capacity will result in output increases and no input price or output price changes but that at levels of output above full capacity, firms have no choice but to raise prices of demand increases. In reality, however, the short-run aggregate supply curve isn’t flat and then vertical. Rather, it becomes steeper as we move from left to right on the diagram. Explain why. What circumstances might lead to an equilibrium at a very flat portion of the AS curve? at a very steep portion?


Using aggregate supply and aggregate demand curves to illus-

trate, describe the effects of the following events on the price level and on equilibrium GDP in the long run assuming that input prices fully adjust to output prices after some lag:

a. An increase occurs in the money supply above potential GDP

b. A decrease in government spending and in the money sup- ply with GDP above potential GDP occurs

c. Starting with the economy at potential GDP, a war in the Middle East pushes up energy prices temporarily. The Fed expands the money supply to accommodate the inflation.


Two separate capacity constraints are discussed in this chapter:

(1) the actual physical capacity of existing plants and equip- ment, shown as the vertical portion of the short-run AS curve, and (2) potential GDP, leading to a vertical long-run AS curve. Explain the difference between the two. Which is greater, full- capacity GDP or potential GDP? Why?


In country A, all wage contracts are indexed to inflation. That is, each month wages are adjusted to reflect increases in the cost of living as reflected in changes in the price level. In country B, there are no cost-of-living adjustments to wages, but the work- force is completely unionized. Unions negotiate 3-year contracts. In which country is an expansionary monetary policy likely to have a larger effect on aggregate output? Explain your answer using aggregate supply and aggregate demand curves.

9. During 2001, the U.S. economy slipped into a recession. For the next several years, the Fed and Congress used monetary and fis- cal policies in an attempt to stimulate the economy. Obtain data on interest rates (such as the prime rate or the federal funds rate). Do you see evidence of the Fed’s action? When did the Fed begin its expansionary policy? Obtain data on total federal expenditures, tax receipts, and the deficit. (Try www.commerce. gov). When did fiscal policy become “expansionary”? Which policy seems to have suffered more from policy lags?

10. Describe the Fed’s tendency to “lean against the wind.” Do the Fed’s policies tend to stabilize or destabilize the economy?

11. [Related to the Economics in Practice on p. 255] The Economics in Practice describes the increase in food prices around the world in 2008. Since food, in large measure, affects the real income of households, increasing prices will eventually push up wages and have an impact on the aggregate supply curve. Central banks were very worried about the prospects for inflation becoming generalized. To stop the inflation, what would the Fed be likely to do? What are the consequences for the economy? Illustrate graphically how the AD curve is likely to respond? Specifically, what would be the effects on employment and unemployment? How would you, as a board member, decide whether to increase or decrease the money supply?

12. [Related to the Economics in Practice on p. 252] Two of the Fed’s main goals are high levels of output and employment and a low rate of inflation. During times of low output and low inflation, the Fed is likely to lower the interest rate to increase the money supply. During times of high output and high infla- tion, the Fed is likely to increase the interest rate to decrease the money supply. What was the state of the U.S economy in 2008? Go to www.bls.gov and click on CPI to find inflation data, and www.bea.gov to find GDP data. What were the inflation and output numbers in 2008? What was the Fed’s response to the 2008 economy? Go to www.federalreserve.gov and find data on the discount rate changes made by the Fed during 2008. Did the actions of the Fed seem appropriate based on the state of the economy? What were the results of the Fed’s actions?