Online Lesson

Fed Orders Interest Rate Cut

Introduction:

On October 15, 1998 Alan Greenspan and the Board of Governors, in a surprise move ordered short-term interest rates cut by 0.25%. What prompted the Fed to take this action? What impact will the rate change have on the economy? Analyze the articles below to examine the linkages between actions of the Federal Reserve Bank and economic performance.

Process:

The paragraphs below are excerpted from a Washington Post article "A Tap on the Gas," appearing Sunday, October 18, 1998. Read and answer the questions that follow.

• "In easing short-term interest rates another click the other day, Federal Reserve Board Chairman Alan Greenspan made a welcome move in the right direction. Large weak spots have developed in the world economy; some part of the weakness has begun to lap back on U.S. shores.

  Some politicians in both parties would rather that they be the ones to lift the economy when it flags. For reasons having only partly to do with economic health, they want to vote tax cuts or spending increases. The votes redound to their credit and help them to model the government according to their views as well. A tax cut or a spending increase in the name of stimulus can achieve other social goals at the same time.

  But (using the budget to manage the economy) can be a clumsy instrument. Public works programs and other spending programs are often too slow to take effect; by the time the stimulus is felt, the economy is already on the way to recovery. The risks of tax-cutting are likewise high. A government facing the claims that his one does - somehow to squirrel away funds against the retirement of the baby boomers while maintaining national defense and adequate levels of public investment and support for the poor - can ill afford to give up revenue."

In another Post article "Why a 2nd Rate Cut?: Analysts Cite the Need to Calm Debt Markets" appearing on October 17, 1998, author John M. Berry writes:

"Federal Reserve Chairman Alan Greenspan's decision Thursday to cut short-term interest rates so surprised financial markets that yesterday rumors continued to fly that some specific problem, such as the imminent failure of a major bank, must have prompted his action.

Fed officials, who generally prefer moving rates up and down by a quarter-percentage point at a time, did not want to scare already jittery investors and lenders by making a large initial reduction."

Read "Fed Cuts Rates Quarter Point."
www.marketwatch.com/News/Story/Story.aspx?guid=%7B4AD29259%2D47BE%2D41A7%2DAA9D%2D97BC81E50F91%7D&siteid=google&dist=google

In a statement announcing the drop in the FFR, the Fed said, "Growing caution by lenders and unsettled conditions in financial markets more generally are likely to be restraining aggregate demand in the future.
Further easing of the stance of monetary policy was judged to be warranted to sustain economic growth in the context of contained inflation."

Draw a graph illustrating this scenario.

• What could happen to aggregate output if aggregate demand is "restrained"?

Do you believe the Fed made the right move in deciding to lower the Federal Funds Rate?