Fed's Options During the Great Recession

Monetary Policy Federal Reserve Money Supply Policy Options at the Beginning of the Great Recession money supply in October of 2008 was $1.4573 trillion, but by December of the same year it had reached $1.6038 trillion. By comparison, the prime interest rate declined from 4.56 to 3.61% during the same period. The slope and y-intercept of the line is -6.2914 and 13.7284, respectively, which allows a calculation of expected interest rates for any value of money supply.

In the figure to the right, MS1 is $1.52 trillion dollars and the expected interest rate would be 4.166%, but if money supply increased to $1.57 trillion (MS2) the prime interest rate would be expected to decline to 3.851%, assuming inflation remains constant. For the same period, gross domestic investment decreased from $3.0816 to $2.8917 trillion as the bank prime interest rate declined from 4.56 to 3.61%. The slope and y-intercept for this line is 5.002 and -10.856, respectively.

As shown in the figure, the direction of this relationship is the opposite of what would be expected under normal economic conditions. Normally, a decline in interest rates would drive an increase in investment. The data presented here reveals the absence of a causal relationship between interest rates and investment demand, which would be consistent with investors exiting the market. This period represents the very beginning of the Great Recession.

Under normal circumstances, the Federal Reserve would attempt to increase the money supply to lower interest rates, thereby spurring investment and an increase in GDP. Between October and December 2008, the consumer price index and the real GDP were in a freefall. The short-term aggregate supply line has a slope of 0.080062 and a y-intercept of -0.19741. During this period, real GDP would be predicted to grow $68.8 billion for every $100 billion of investment.

This is shown in the figure to the right, where ADo represents the current aggregate demand line and ADo+?I represents a $100 billion increase in investment. The GDP multiplier would predict an actual increase in GDP of $169 billion, from $14.64 to $14.81 trillion (AD1) for this period if the Fed implemented an expansionary monetary policy. The reserve requirement for this period went from $47.642 to $53.642 billion between October and December 2008, for an average of $50.642 billion.

Using the formula for the money multiplier (1/reserve requirement) the money multiplier would be 0.0197, or $20 billion for every 100 billion increase in GDP. The aggregate demand curve labeled AD2 represents an increase from $14.64 to $14.83 trillion GDP. The marginal propensity to consume (MPC) represents the change in consumer consumption as income changes. Between October and December 2008, consumption went from $9.9748 to $9.7369 billion and income declined from $11.0084 to $10.8587 trillion. The change in consumption was -- $0.2379 billion and the change in income was -- $149.7 billion; therefore, MPC = -- 0.2379 / -- 149.7 = -- 0.0015891.

The multiplier would be 1/(1 -- MPC) = 1/(1 -- 0.0015891) =.