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3 In practice, the price level rarely falls.What the Fed actually achieves in this case is a decrease in the rate of inflationthat is, inthe percentage change in the price levelnot 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.

E C O N O M I C S I N P R A C T I C E

Federal Reserve Behavior in 2008The U.S. economy was in serious trouble in 2008.The problem began in the housing and mortgage

markets. In 20032005, housing prices rose rapidly in what some called a housing bubble. Banksissued mortgages to some people with poor creditratings, so-called sub-prime borrowers, andencouraged other people to take out mortgages they could not necessarily afford. There was very littleregulation of these activities and investors took onhuge 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 thancommercial banks and guaranteed $30 billion of Bear Stearns liabilities to JPMorgan. Nolonger was the Fed just a lender of last resort. On September 7, 2008, the Fed participated in agovernment 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 tohelp it avoid bankruptcy. In mid September, the Fed urged Congress to pass a $700 billionbailout 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 percentto 3.50 percent.The Fed then lowered the rate further to 3.00 percent on January 30. On March18, 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 aboutboth inflation and output. Inflation was a concern in early 2008 because of rising food andcommodity prices, particularly oil prices. (See the Economics in Practicebox on p. 255.) Butoutput was more of a concern. The fall in housing prices led to a fall in housing investment.(See the Economics in Practicebox 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 inoutput. The Fed responded by lowering interest rates.

What about the other moves the Fed made in 2008? These nontraditional moves weredesigned to deal with the fact that many large financial institutions had bet on rising housingprices 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 20032005.

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 canincrease the interest rate (and thus decrease the money supply) with little effect on output. Thecontractionary monetary policy will shift the AD curve to the left, which will lead to a fall in theprice level and little effect on output. 3 The Fed is likely to increase the interest rate (and thusdecrease the money supply) during times of high output and high inflation. In this discussion, wesee 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 willrise, 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 todraw AS/AD diagrams to see why this is true.) The Fed is faced with a trade-off. In this case, theFeds decisions depend on how it weights output relative to inflation. If it dislikes high inflation

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5. [Related to the Economics in Practice on p. 243 ] The Economicsin Practice describes the simple Keynesian aggregate supply curveas one in which there is a maximum level of output given theconstraints of a fixed capital stock and a fixed supply of labor.The presumption is that increases in demand when firms areoperating below capacity will result in output increases and noinput 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 aggregatesupply curve isnt flat and then vertical.Rather, it becomessteeper as we move from left to right on the diagram. Explainwhy. What circumstances might lead to an equilibrium at a very flat portion of the AS curve? at a very steep portion?

6. Using aggregate supply and aggregate demand curves to illus-trate, describe the effects of the following events on the pricelevel and on equilibrium GDP in the long run assuming thatinput prices fully adjust to output prices after some lag:a. An increase occurs in the money supply above potential GDPb. A decrease in government spending and in the money sup-

ply with GDP above potential GDP occursc. Starting with the economy at potential GDP, a war in the

Middle East pushes up energy prices temporarily. The Fedexpands the money supply to accommodate the inflation.

7. 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?

8. 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 tohave a larger effect on aggregate output? Explain your answerusing aggregate supply and aggregate demand curves.

9. During 2001, the U.S. economy slipped into a recession. For thenext several years, the Fed and Congress used monetary and fis-cal policies in an attempt to stimulate the economy. Obtain dataon interest rates (such as the prime rate or the federal fundsrate). Do you see evidence of the Feds action? When did the Fedbegin its expansionary policy? Obtain data on total federalexpenditures, tax receipts, and the deficit. (Try www.commerce.

gov). When did fiscal policy become expansionary? Whichpolicy seems to have suffered more from policy lags?10. Describe the Feds tendency to lean against the wind. Do the

Feds policies tend to stabilize or destabilize the economy?11. [Related to the Economics in Practice on p. 255 ] The

Economics in Practicedescribes the increase in food pricesaround the world in 2008. Since food, in large measure, affectsthe 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 forinflation becoming generalized. To stop the inflation, whatwould the Fed be likely to do? What are the consequences for theeconomy? Illustrate graphically how the AD curve is likely torespond? Specifically, what would be the effects on employmentand 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

Feds main goals are high levels of output and employment anda low rate of inflation. During times of low output and low inflation, the Fed is likely to lower the interest rate to increasethe money supply. During times of high output and high infla-tion, the Fed is likely to increase the interest rate to decrease themoney 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, andwww.bea.gov to find GDP data.What were the inflation andoutput numbers in 2008? What was the Feds response to the2008 economy? Go to www.federalreserve.gov and find data onthe discount rate changes made by the Fed during 2008. Did theactions of the Fed seem appropriate based on the state of theeconomy? What were the results of the Feds actions?

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