How do changes in short-term interest rates affect the overall economy? In the short run, an
expansionary monetary policy that reduces interest rates increases interest-sensitive spending, all
else equal. Interest-sensitive spending includes physical investment (i.e., plant and equipment) by
firms, residential investment (housing construction), and consumer-durable spending (e.g.,
automobiles and appliances) by households. As discussed in the next section, it also encourages
exchange rate depreciation that causes exports to rise and imports to fall, all else equal. To reduce
spending in the economy, the Fed raises interest rates, and the process works in reverse. An
examination of U.S. economic history will show that money- and credit-induced demand
expansions can have a positive effect on U.S. GDP growth and total employment. The extent to
which greater interest-sensitive spending results in an increase in overall spending in the
economy in the short run will depend in part on how close the economy is to full employment.
When the economy is near full employment, the increase in spending is likely to be dissipated
through higher inflation more quickly. When the economy is far below full employment,
inflationary pressures are more likely to be muted. This same history, however, also suggests that
over the longer run, a more rapid rate of growth of money and credit is largely dissipated in a
more rapid rate of inflation with little, if any, lasting effect on real GDP and employment. (Since
the crisis, the historical relationship betw