The vertical axis on the left of figure 14 12 shows

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Unformatted text preview: shows that the Federal Reserve did indeed tend to cut interest rates when the economy had a recessionary gap and raise interest rates when the economy had an inflationary gap. The vertical axis on the left of Figure 14-12 shows the federal funds rate; the line labeled “federal funds rate” shows the average yearly value of that rate between 1985 and 2004. The vertical axis on the right shows the Congressional Budget Office estimate of the output gap, measured as a percentage of potential output. This number is positive when there is an inflationary gap, as in 1999 and 2000, and negative when there is a recessionary gap, as in 2001 through 2004. 14-12 10% 3% Federal funds rate 8 2 1 6 0 4 –1 –2 Output gap 2 –3 –4 As you can see, there’s a positive association between the federal funds rate and the output gap: the Fed tended to raise interest rates when aggregate output was moving above potential output and to reduce them when aggregate output was moving below potential output. In other words, the Fed was following pretty much the policy illustrated in Figures 14-8 and 14-9. The two lines aren’t perfectly synchronized. As you can see, the Fed did not raise interest rates in 1998 and 1999, even though the economy had developed a substantial 04 20 00 20 95 19 90 0 19 The left vertical axis shows the federal funds rate. The right vertical axis shows the output gap, measured as the difference between actual and potential output as a percentage of potential output. Over the past 20 years, the Fed has pursued a contractionary monetary policy, raising the federal funds rate when the economy was operating above potential output— that is, when there was an inflationary gap. It has pursued an expansionary monetary policy, reducing the federal funds rate when the economy was operating below potential output—that is, when there was a recessionary gap. Output gap (percent of potential output) Federal funds rate 85 Federal Reserve Policy and the Business Cycle 19 Figure Year 359 360 ®® ® ® ® PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S QUICK REVIEW The Federal Reserve can use expansionary monetary policy to close a recessionary gap and contractionary monetary policy to close an inflationary gap. Like fiscal policy, monetary policy gives rise to a multiplier effect through changes in the interest rate that affect aggregate spending and savings. In the short run, the equilibrium interest rate in the economy is determined in the money market by the liquidity preference model. Changes in the interest rate induce changes in aggregate output and savings, and the loanable funds market adjusts to the equilibrium interest rate arising in the money market. UNCORRECTED Preliminary Edition inflationary gap. We’ll explain why in Chapter 17, when we discuss monetary policy controversies. For now, let’s just say that some economists believe that the Fed should have raised rates. Also, data from years earlier than 1985 look very different. Prior to 1985 the Fed was grappling with the problem of inflationary expectations, which we will dis...
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