This is illustrated in panel a by the rightward shift

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Unformatted text preview: rned in Chapter 13, an open-market purchase of Treasury bills leads to an increase in the money supply. This is illustrated in panel (a) by the rightward shift of the money supply curve from MS1 to MS2 and an increase in the money supply to M 2. This drives the interest rate, r1, down to the target rate, rT. Panel (b) shows the opposite case. Again, the initial money supply curve is MS1 with money supply M 1. But this time the equilibrium interest rate, r1, is below the target federal funds rate, rT. In this case, the Fed will make an open-market sale of Treasury bills, leading to a fall in the money supply to M 2. The money supply curve shifts leftward from MS1 to MS2, driving the short-term interest rate up to the target federal funds rate, rT. economics in action The Fed Takes Action In January 2001 the Federal Reserve, alarmed by signs of a looming recession, began cutting the target federal funds rate. We’ll explain in the next section why the Fed believed this would be the correct response to a recession. But for now, let’s focus on the Fed’s ability to move interest rates. Figure 14-7 on page 354 shows the movements of three interest rates between 1999 and 2005: the actual federal funds rate, the prime rate, and the 30-year mortgage rate. As you can see, the January 2001 cut in the federal funds rate was followed by several more. In fact, by the end of 2001 the Fed had cut the target federal funds rate 10 times, bringing it down from 6% at the beginning of 2001 to 1.75% at the end of 2001. (This was achieved by making cuts between regular meetings of the FOMC.) In 2002 the Fed cut the target again, to 1.25%; in 2003 it cut the target even further, to just 1%. In 2004, in response to signs of a growing economy, the Fed began gradually raising its target again, by 0.25 percentage point at each meeting. M O N E TA R Y P O L I C Y 353 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 14-7 30-year mortgage rate 8 6 Federal funds rate 05 20 4 2 3 20 0 19 20 0 2 Prime rate 20 0 4 99 In early 2001, in response to a weakening economy, the Fed began cutting the federal funds rate. The prime rate—the interest rate on short-term bank loans to their best customers—fell in parallel. The 30-year mortgage rate, which is used by consumers buying homes, fell, too, though not as much. By 2004, in the face of a growing economy, the Fed began raising the federal funds rate. Interest rate, r 10% 1 The Fed Moves Interest Rates 20 0 Figure UNCORRECTED Preliminary Edition 0 PA R T 5 20 0 354 Year ®® ® ® QUICK REVIEW The liquidity preference model of interest rates says that the equilibrium interest rate is determined by the money demand curve and the money supply curve. The Federal Reserve can move the interest rate through open-market operations that shift the money supply curve. In practice, the Fed sets a target federal funds rate, and uses open-market operations to achieve that target. The second interest rate shown in Figure 14-7 is the prime rate, the short-term rate that banks charge on loans to their best customers. This is a measure of how much it costs businesses to borrow; it’s always above the feder...
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This note was uploaded on 09/09/2009 for the course ECON 701 taught by Professor Charlie during the Spring '09 term at École Normale Supérieure.

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