© 2013 Pearson

Did the Fed save us from

another Great Depression?
© 2013 Pearson
Monetary Policy
33
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Describe the objectives of U.S. monetary policy, the
framework for achieving those objectives, and the Fed’s
monetary policy actions.

2 Explain the transmission channels through which the Fed

influences real GDP and the inflation rate.

3 Explain and compare alternative monetary policy

strategies.
© 2013 Pearson
33.1 HOW THE FED CONDUCTS MONETARY POLICY

 Monetary Policy Objectives

The objectives of monetary policy are ultimately political.
The objectives are set out in the mandate of the Board of
Governors of the Federal Reserve System.
The mandate is defined by the Federal Reserve Act of
1913 and its subsequent amendments.
The objectives have two distinct parts: a statement of
goals and a prescription of the means by which to pursue
them.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY
Federal Reserve Act

Federal Reserve Act passed by Congress in 2000 states

that:
The Board of Governors of the Federal Reserve System
and the Federal Open Market Committee shall maintain
long-run growth of the monetary and credit aggregates
commensurate with the economy’s long-run potential to
increase production, …
so as to promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest
rates.
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33.1 HOW THE FED CONDUCTS MONETARY POLICY
Goals: The Dual Mandate
The Fed’s goals, often called the “dual mandate,” are to
achieve stable prices and full employment.
The goal of “stable prices” means keeping the inflation rate
low.
The goal of “maximum employment” means attaining the
maximum sustainable growth rate of potential GDP, keeping
real GDP close to potential GDP and the unemployment
rate close to the natural unemployment rate.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY
Means for Achieving the Goals

The 2000 law instructs the Fed to pursue its goals.

The “economy’s long-run potential to increase production” is
the growth rate of potential GDP.
The “monetary and credit aggregates” are the quantities of
money and loans.
By keeping the growth rate of the quantity of money in line
with the growth rate of potential GDP, the Fed is expected to
be able to maintain full employment and keep the price level
stable.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY
Prerequisites for Achieving the Goals

The financial crisis brought the problem of financial

instability to the top of the Fed’s agenda.

The focus of policy became the single-minded pursuit of

financial stability—a situation in which financial markets
and institutions function normally to allocate capital
resources and risk.

Financial stability is a prerequisite for attaining the goals.

Financial instability has the potential to undermine the

attainment of the mandated goals.
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33.1 HOW THE FED CONDUCTS MONETARY POLICY

 Operational “Maximum Employment” Goal

The Fed pays close attention to the business cycle and
tries to steer a steady course between recession and
inflation.
The Fed tries to minimize the output gap—the
percentage deviation of real GDP from potential GDP.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

 Operational “Stable Prices” Goal

The Fed believes that core inflation provides the best
indication of whether price stability has been achieved.
Core inflation is the annual percentage change in the
Personal Consumption Expenditure deflator (PCE
deflator) excluding the prices of food and fuel.
The Fed has not defined price stability, but many
economists regard it as a core inflation rate of between
1 and 2 percent a year.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

 Responsibility for Monetary Policy

The Federal Reserve Act makes the Board of
Governors of the Federal Reserve System and the
Federal Open Market Committee (FOMC) responsible
for the conduct of monetary policy.
The FOMC makes a monetary policy decision at eight
scheduled meetings a year and publishes the minutes
three weeks after each meeting.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

Congress plays no role in making monetary policy

decisions but the Federal Reserve Act requires the
Board of Governors to report on monetary policy to
Congress.
The Fed makes two reports to Congress each year.
The formal role of the President of the United States is
limited to appointing the members and the Chairman of
the Board of Governors.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

 Choosing a Policy Instrument

To conduct its monetary policy, the Fed must select a
monetary policy instrument.
A monetary policy instrument is a variable that the
Fed can directly control or closely target and that
influences the economy in desirable ways.
As the sole issuer of monetary base, the Fed has a
monopoly and can fix either the quantity or the price of
monetary base.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

The price of monetary base is the federal funds rate.

Federal funds rate is the interest rate at which banks
can borrow and lend reserves in the federal funds
market.
The Fed can target the quantity of monetary base or the
federal funds rate, but not both.
If the Fed wants to decrease the monetary base, the
federal funds rate must rise.
If the Fed wants to raise the federal funds rate, the
monetary base must decrease.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

 The Federal Funds Rate

The Fed’s choice of monetary policy instrument is the
federal funds rate.
Given this choice, the Fed permits the monetary base
and the quantity of money to find their own equilibrium
values and has no preset targets for them.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

Figure 33.1 shows the

federal funds rate
since 2000.
The Fed sets a target
for the federal
funds rate and then
takes actions to
keep the rate close to
target.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

When the Fed wants

to slow inflation,
it raises the federal
funds rate target.

When the inflation rate

is below target
and the Fed wants to
avoid recession,
it lowers the federal
funds rate.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

 The Fed’s Decision-Making Strategy

Two alternative decision-making strategies might be
used.
They are summarized by the terms:
• Instrument rule
• Targeting rule

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

Instrument Rule
An instrument rule is a decision rule for monetary
policy that sets the policy instrument by a formula based
on the current state of the economy.
The best-known instrument rule for the federal funds
rate is the Taylor Rule.
The Taylor rule sets the federal funds rate by a formula
that links it to the current inflation rate and current
estimate of the output gap.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

Targeting Rule
A targeting rule is a decision rule for monetary policy
that sets the policy instrument at a level that makes the
central bank’s forecast of the ultimate policy goals equal
to their targets.
If the ultimate policy goal is a 2 percent inflation rate
and the instrument is the federal funds rate, …
then the targeting rule sets the federal funds rate at a
level that makes the forecast of the inflation rate equal
to 2 percent a year.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

 Hitting the Federal Funds Rate Target

The federal funds rate is the interest rate that banks
earn (or pay) when they lend (or borrow) reserves.
The federal funds rate is also the opportunity cost of
holding reserves.
Holding a larger quantity of reserves is the alternative to
lending reserves to another bank.
Holding a smaller quantity of reserves is the alternative
to borrowing reserves from another bank.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

So the quantity of reserves that banks are willing to hold

varies with the federal funds rate:
The higher the federal funds rate, the smaller is the
quantity of reserves that the banks plan to hold.
The Fed controls the quantity of reserves supplied.
The Fed can change this quantity of reserves supplied
by conducting an open market operation.
To hit the federal funds rate target, the Fed conducts
open market operations until the supply of reserves is at
just the right quantity to hit the target federal funds rate.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY
Figure 33.2 shows the
market for bank reserves.
The higher the federal funds
rate, the smaller is the
quantity of reserves that
banks want to hold.
The demand for bank
reserves is RD.
1. The FOMC sets the
federal funds target at 5
percent a year.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

2. The New York Fed

conducts an open market
operation to make the
quantity of reserves
supplied equal to $50
billion and the supply of
reserves is RS.

3. Equilibrium in the market

for bank reserves occurs
at the target federal funds
rate.
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33.1 HOW THE FED CONDUCTS MONETARY POLICY

 Restoring Financial Stability in a Financial

Crisis
During the global financial crisis, the Fed took
extraordinary steps to restore financial stability.
The Fed used quantitative easing and credit easing.
An enormous surge in bank reserves and the monetary
base occurred during 2008.
Figure 33.3 illustrates the Fed’s crisis polices in the
market for bank reserves.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY
In normal times, the
demand for reserves is
RD0 and the supply of
reserves is RS0.

The federal funds rate is

5 percent a year and
bank reserves are $50
billion.

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33.1 HOW THE FED CONDUCTS MONETARY POLICY

In a financial crisis:

1. The banks face increased

risk and their demand for
reserves increases to RD1.

If the Fed took no action, the

federal funds rate would rise,
bank lending would shrink.

The quantity of money would

decrease and a recession
would intensify.
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33.1 HOW THE FED CONDUCTS MONETARY POLICY

To avoid this outcome,

2. The Fed’s QE1 and

other actions increase the
supply of reserves to RS1.

3. The equilibrium Federal

funds rate falls to zero and
reserves increase to $1,000
billion.

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33.2 MONETARY POLICY TRANSMISSION

When the Fed changes the federal funds rate, events

ripple through the economy and lead to the ultimate
policy goals.

 Quick Overview
Figure 33.4 summarizes the ripple effects.

© 2013 Pearson
© 2013 Pearson
33.2 MONETARY POLICY TRANSMISSION

Interest Rate Changes

1. The first effect of a
monetary policy decision by the
FOMC is a change in the
federal funds rate.
2. Other interest rates then
change quickly and
relatively predictably.

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33.2 MONETARY POLICY TRANSMISSION

Exchange Rate Changes

The exchange rate responds to changes in the interest
rate in the United States relative to the interest rates in
other countries—the U.S. interest rate differential.
When the Fed raises the federal funds rate, the U.S.
interest rate differential rises and, other things remaining
the same, the U.S. dollar appreciates.
And when the Fed lowers the federal funds rate, the U.S.
interest rate differential falls and, other things remaining
the same, the U.S. dollar depreciates.
© 2013 Pearson
33.2 MONETARY POLICY TRANSMISSION

 Money and Bank

Loans
3. To change the federal funds
rate, the Fed must change
the quantity of bank
reserves, which in turn
changes the quantity of
deposits and loans that the
banking system can create.

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33.2 MONETARY POLICY TRANSMISSION

 The Long-Term Real

Interest Rate
4. Changes in the federal
funds rate change the
supply of bank loans, which
changes the supply of
loanable funds and changes
the real interest rate in the
loanable funds market.

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33.2 MONETARY POLICY TRANSMISSION

 Expenditure Plans
5. A change in the real interest
rate changes consumption
expenditure, investment,
and net exports.
6. A change in consumption
expenditure, investment,
and net exports changes
aggregate demand.

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33.2 MONETARY POLICY TRANSMISSION
7. About a year after the
change in the federal funds
rate occurs, real GDP
growth changes.
8. About two years after the
change in the federal funds
rate occurs, the inflation rate
changes.

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33.2 MONETARY POLICY TRANSMISSION

 The Fed Fights Recession

With inflation below target and real GDP below potential
GDP, the Fed fears recession.
Figure 33.5 illustrates how the Fed’s policy works.

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33.2 MONETARY POLICY TRANSMISSION

Figure 33.5(a) shows the

market for bank reserves.

1. The FOMC lowers the

federal funds rate target
from 5 percent to 4
percent a year.

2. The New York Fed buys

securities on the open
market, which increases
bank reserves to hit the
federal funds rate target.
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33.2 MONETARY POLICY TRANSMISSION

Figure 33.5(b) shows the

money market.

3. The supply of money

increases.

The short-run interest

rate falls from 5 percent
to 4 percent a year and
the quantity of real
money increases.

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33.2 MONETARY POLICY TRANSMISSION

Figure 33.5(c) shows the

market for loanable funds.

4. An increase in the
supply of loans
increases the supply of
loanable funds.

The real interest rate

falls and the quantity of
investment increases.

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33.2 MONETARY POLICY TRANSMISSION

Figure 33.5(d) shows the

recessionary gap.
5. An increase in
expenditure increases
aggregate demand by ∆E.

6. A multiplier effect
increases aggregate
demand to AD1.

Real GDP increases and

the inflation rises.
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33.2 MONETARY POLICY TRANSMISSION

 The Fed Fights Inflation

If the inflation rate is too high and real GDP is above
potential GDP, the Fed takes action to lower the inflation
rate and restore price stability.
Figure 33.6 illustrates how the Fed’s policy works.

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33.2 MONETARY POLICY TRANSMISSION

Figure 33.6(a) shows the

market for bank reserves.

1. The FOMC raises the

federal funds rate target
from 5 percent to 6
percent a year.

2. The New York Fed sells

securities on the open
market, which decreases
bank reserves to hit the
federal funds rate target.
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33.2 MONETARY POLICY TRANSMISSION

Figure 33.6(b) shows the

money market.

3. The supply of money

decreases.

The short-run interest

rate rises from 5 percent
to 6 percent a year and
the quantity of real money
decreases.

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33.2 MONETARY POLICY TRANSMISSION

Figure 33.6(c) shows the

market for loanable funds.

4. A decrease in the supply

of loans decreases the
supply of loanable funds.

The real interest rate

rises and the quantity of
investment decreases.

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33.2 MONETARY POLICY TRANSMISSION

Figure 33.6(d) shows the

inflationary gap.
5. A decrease in expenditure
decreases aggregate
demand by ∆E.

6. A multiplier effect
decreases aggregate
demand to AD1.

Real GDP decreases and

the inflation slows.
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33.2 MONETARY POLICY TRANSMISSION

 Loose Links and Long and Variable Lags

You’re seen the ripple effects of a change in monetary
policy.
In reality, these ripple effects are hard to predict and
anticipate.
Figure 33.4 shows that the ripple effects stretch out over
a two-year period.

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33.2 MONETARY POLICY TRANSMISSION

Loose Links from Federal Funds Rate to Spending

The long-term real interest rate that influences spending
plans is linked only loosely to the federal funds rate.
Also, the response of the long-term real interest rate to
a change in the nominal rate depends on how inflation
expectations change.
The response of expenditure plans to changes in the
real interest rate depends on many factors that make
the response hard to predict.

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33.2 MONETARY POLICY TRANSMISSION

Time Lags in the Adjustment Process

The monetary policy transmission process is long and
drawn out.
Also, the economy does not always respond in exactly
the same way to a given policy change.
Further, many factors other than policy are constantly
changing and bringing new situations to which policy
must respond.

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33.2 MONETARY POLICY TRANSMISSION

 A Final Reality Check

The time lags in the adjustment process are not
predictable, but the average time lags are known.
After the Fed takes action, real GDP begins to change
about one year later and the inflation rate responds with
a lag that averages around two years.
This long time lag between the Fed’s action and a
change in the inflation rate, the ultimate policy goal,
makes monetary policy very difficult to implement.

© 2013 Pearson
33.3 ALTERNATIVE MONETARY POLICY STRATEGIES

 Why Rules?
The alternative to a monetary policy rule is discretionary
monetary policy.
Discretionary monetary policy is a monetary policy
that is based on an expert assessment of the current
economic situation.
A well-understood monetary policy rule helps to keep
inflation expectations anchored close to the inflation
target and creates an environment in which inflation is
easier to forecast and manage.
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33.3 ALTERNATIVE MONETARY POLICY STRATEGIES

Although rules beat discretion, there are three

alternative rules that the Fed might have chosen. They
are
• An inflation targeting rule
• A money targeting rule
• Nominal GDP targeting rule

© 2013 Pearson
33.3 ALTERNATIVE MONETARY POLICY STRATEGIES

 Inflation Targeting Rule

Inflation targeting is a monetary policy strategy in
which the central bank makes a public commitment to
achieving an explicit inflation target and to explaining
how its policy actions will achieve that target.
Of the alternatives to the Fed’s current strategy, inflation
targeting is the most likely to be considered. In fact,
some economists see it as a small step from what the
Fed currently does.

© 2013 Pearson
33.3 ALTERNATIVE MONETARY POLICY STRATEGIES

How Inflation Targeting Is Conducted

Inflation targets are specified in terms of a range for the
CPI inflation rate.
This range is typically between 1 percent and 3 percent
a year, with an aim to achieve an average inflation rate
of 2 percent a year.
Because the lags in the operation of monetary policy
are long, if the inflation rate falls outside the target
range, the expectation is that the central bank will move
the inflation rate back on target over the next two years.
© 2013 Pearson
33.3 ALTERNATIVE MONETARY POLICY STRATEGIES

What Does Inflation Targeting Achieve?

The idea of inflation targeting is to state publicly the
goals of monetary policy, to establish a framework of
accountability, and to keep the inflation rate low and
stable while maintaining a high and stable employment.
There is wide agreement that inflation targeting
achieves its first two goals.
It is less clear whether inflation targeting does better
than the Fed’s implicit targeting in achieving low and
stable inflation.

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33.3 ALTERNATIVE MONETARY POLICY STRATEGIES

 Money Targeting Rule

An example is Friedman’s k-percent rule.
The k-percent rule is a monetary policy rule that
makes the quantity of money grow at k percent per
year, where k equals the growth rate of potential GDP.
Money targeting works when the demand for money is
stable and predictable.
But technological change in the banking system leads to
unpredictable changes in the demand for money, which
makes money targeting unreliable.
© 2013 Pearson
33.3 ALTERNATIVE MONETARY POLICY STRATEGIES

 Nominal GDP Targeting Rule

Nominal GDP targeting is a monetary policy rule that
adjusts the interest rate to achieve a target growth rate
for nominal GDP.
The target might be set by the government or adopted
by the central bank.
Growth rate of nominal GDP equals the growth rate of
real GDP plus the inflation rate, as measured by the
GDP price index.

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33.3 ALTERNATIVE MONETARY POLICY STRATEGIES

The growth rate of real GDP, on average, keeps

returning to the trend growth rate, so nominal GDP
targeting is a version of inflation targeting.
Under this policy, the Fed would adjust the interest rate
when either inflation departs from its target or real GDP
growth departs from its long-term growth rate.
Nominal GDP targeting is an old idea that many
economists have recommended, but it gained
momentum during 2011.

© 2013 Pearson
 Did the Fed Save Us from Another Great
Depression?

The story of the Great Depression is complex and even

today, after almost 80 years of research, economists are
not in full agreement on its causes.

But one part of the story is clear and it is told by Milton

Friedman and Anna J. Schwartz:

The Fed got it wrong.

© 2013 Pearson
 Did the Fed Save Us from Another Great
Depression?
An increase in financial risk
drove the banks to increase their
holdings of reserves and
everyone else to lower their bank
deposits and hold more currency.

Between 1929 and 1933, the

banks’ desired reserve ratio
increased from 8 percent to
12 percent and …

the currency drain ratio increased

from 9 percent to 19 percent.

© 2013 Pearson
 Did the Fed Save Us from Another Great
Depression?
The money multiplier fell from
6.5 to 3.8.

The quantity of money crashed

by 35 percent.

This massive contraction in the

quantity of money was
accompanied by a similar
contraction of bank loans.

A large number of banks failed.

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 Did the Fed Save Us from Another Great
Depression?
Friedman and Schwartz say that
this contraction of money and
bank loans and the failure of
banks could have been avoided
by a more alert and wise Fed.

The Fed could have

accommodated the banks’
increased desired reserve ratio
and ...

offset the rise in currency

holdings as people switched out
of bank deposits.
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 Did the Fed Save Us from Another Great
Depression?
Bernanke followed Friedman
and Schwartz’s suggestion.

At the end of 2008, the Fed

flooded the banks with the
reserves that they wanted.

The money multiplier fell from

9.1 in 2008 to 4.6 in 2009—
much more than it had fallen
from 1929 to 1933.

The quantity of money did not

contract as it did in 1933.
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 Did the Fed Save Us from Another Great
Depression?
We can’t be sure that the Fed
averted a Great Depression in
2009.

But we can be confident that

the Fed’s actions helped to
limit the depth and duration of
the 2008–2009 recession.

© 2013 Pearson