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Episode 3

However, in Episode 3 in the late 1980s, inflation appeared to be creeping up again, rising from 2% in 1986 up toward 5% by 1989. In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6.6% in 1987 to 9.2% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but it also helped to cause the recession of 1990–1991, and the unemployment rate rose from 5.3% in 1989 to 7.5% by 1992.

Episode 4

In Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to 3.5% in 1992. As the economy expanded, the unemployment rate declined from 7.5% in 1992 to less than 5% by 1997.

Episodes 5 and 6

In Episodes 5 and 6, the Federal Reserve perceived a risk of inflation and raised the federal funds rate from 3% to 5.8% from 1993 to 1995. Inflation did not rise, and the period of economic growth during the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4.6% in December 1998 to 6.5% in June 2000. By early 2001, inflation was declining again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0% to 5.8%.

Episodes 7 and 8

In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2% in 2000 to just 1.7% in 2002, and then again to 1% in 2003. They actually did this because of fear of Japan-style deflation; this persuaded them to lower the Fed funds further than they otherwise would have. The recession ended, but, unemployment rates were slow to decline in the early 2000s. Finally, in 2004, the unemployment rate declined and the Federal Reserve began to raise the federal funds rate until it reached 5% by 2007.

Episode 9

In Episode 9, as the Great Recession took hold in 2008, the Federal Reserve was quick to slash interest rates, taking them down to 2% in 2008 and to nearly 0% in 2009. When the Fed had taken interest rates down to near-zero by December 2008, the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The Federal Reserve had to think “outside the box.”

Quantitative easing

The most powerful and commonly used of the three traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate. In late 2008, as the U.S. economy struggled with recession, the Federal Reserve had already reduced the interest rate to near-zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing (QE)    . This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand .

Quantitative easing differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long term Treasury bonds , rather than short term Treasury bills . In 2008, however, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get. (Read the closing Bring it Home feature for more on this.) Therefore, Bernanke sought to lower long-term rates utilizing quantitative easing.

This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed “toxic assets,” because when the housing market collapsed, no one knew what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both pushing long term interest rates down and also removing possibly “toxic assets” from the balance sheets of private financial firms, which would strengthen the financial system.

Quantitative easing (QE) occurred in three episodes:

  1. During QE 1 , which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.
  2. In November 2010, the Fed began QE 2 , in which it purchased $600 billion in U.S. Treasury bonds.
  3. QE 3 , began in September 2012 when the Fed commenced purchasing $40 billion of additional mortgage-backed securities per month. This amount was increased in December 2012 to $85 billion per month. The Fed stated that, when economic conditions permit, it will begin tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final $15 billion purchase of bonds, ending Quantitative Easing.

The quantitative easing policies adopted by the Federal Reserve (and by other central banks around the world) are usually thought of as temporary emergency measures. If these steps are, indeed, to be temporary, then the Federal Reserve will need to stop making these additional loans and sell off the financial securities it has accumulated. The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact. The evidence suggests that QE 1 was somewhat successful, but that QE 2 and QE 3 have been less so.

Key concepts and summary

An expansionary (or loose) monetary policy raises the quantity of money and credit above what it otherwise would have been and reduces interest rates, boosting aggregate demand, and thus countering recession. A contractionary monetary policy, also called a tight monetary policy, reduces the quantity of money and credit below what it otherwise would have been and raises interest rates, seeking to hold down inflation. During the 2008–2009 recession, central banks around the world also used quantitative easing to expand the supply of credit.

Questions & Answers

what is the determination of aggregate demand?
Maddy Reply
classical dichotomy and its components?
Romaisa Reply
what will happen to the demand curve when there is an inflation in an economy
Hamza Reply
From my view, I think the demand curve will shift inwards.
now it depends on what kind of inflation it is, depending on the type of inflation the movement of the demand curve can be stated.
yes it depends on the cause for inflation. if it caused by maybe an increase in money supply, the effect is neutral in the long term, therefore there are no effects on total output in the economy, except for an increase in price
but short term in general i think you could expect the demand curve to shift inwards as consumers experience a decrease in real income
source of capital for the sole trader
Dogbey Reply
borrowing from relatives, government grants, bank loans, personal savings, credit card etc.
Suppose you are holding 2000 in a checking account and the price level decrease by 20 %how much it will affect your purchasing power and why
Iqra Reply
Hi Iqra, will answer your question soon.
2000*0.2= 400 2000-400= 1600
a price level decrease is deflation. it means you'll be able to afford to buy more with your 2000 and your real income becomes 2000÷(100-20)=2500
the amount will decrease to 1600 and you can't be able to buy over this amount
As an economist student discuss how the pandemic covid19 can affect the aggregate demand and aggregate supply thereby leading to decrease in GDP and standard of living of citizens of nigeria
Fadila Reply
hi how can you help me?
qusai Reply
can you send me the notes
hello is what are you talking about?
unemployment and low inflation    .
Abdirizaq Reply
Structure/Organization Of The Federal Reserve
sorry guys in macroeconomics what is different between inflation and intrest rate? please example for pandemic related maybe?
Is this Aap for class 11 and 12 only not for graduation?
ankit Reply
yeah like for du MA entrance
Aree i m also asking
for du MA entrance. u shouldn't rely on app. Go for SAURABH SIR notes. available on flipkart.
ohh thanks
what is inflation
Bright Reply
hike in price
situation of rise in price with the fall in purchasing power of money
cycle of corruption
rise in price of a Nation economy in terms of trade
what is distruptive international trade?
meaning of inflation
Jayakumar Reply
increase in general prices level in an economy.
increase in general price level
The fall in standard of living because goods and services become expensive.
what is value added and how is it used in calculating GDP
Benedicta Reply
value added is final price of output minus cost of production. For example, let's say you make a shirt with raw materials that cost $20, and then sell the shirt for $35 added value would be 35-20=15. In calculating GDP, it is used to avoid double counting goods. Exp. eggs individually and in bread.
as the price of tickets rises from $200 to $250, what is the price elasticity of demand for business travelers, vacationers using midpoint method
Buumba Reply
@jb how do uget $300
It means you are measuring the cost against availability.
Explain how income taxes and transfer payments are used to stabilize the economy
Nakagwa Reply
reduce demand on scarce resources by reducing money supply.
sketch the graph of supply curve
Isamole Reply

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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