MONETARY POLICY

CHERRY B. LECIAS

What are the tools of monetary policy?What is the effect of monetary policy in

the short run?Why doesn’t monetary policy always

work?

BIG QUESTIONS

What are the specific ways the Fed, or the central bank of any country, can promote economic growth?Answer: They use monetary policy to alter the supply.

involves adjusting the money supply to influence the macroeconomy.

What is Monetary Policy?

Monetary Policy

Throw the money out of the back of an armored truck.

Distribute $50,000 in new $100 bills to every private bank.

Use new money to buy something in the economy.

Open Market Operations involve the purchase or sale of bonds by a central bank.

The primary tool that the Fed uses to expand or contract money supply in order to affect the macroeconomy.

1. Open Market Operations

A Bond is a paper IOU that joins two parties in a contract that specifies the conditions for repayment of the loan.

If Fed buys bonds, reserves increase. So money supply increases.If Fed sells bonds, reserves decrease. So money supply decreases.

Financial Institutio

nFed

Financial InstitutionFed

Open Market OperationsIn open market purchases,the Fed buys governmentbonds from “financialinstitutions. This actioninjects new money directlyinto “financial markets. Inopen market sales, theFed sells bonds back to" financial institutions. Thisaction takes money out of" financial markets.

government bonds

government bonds$$

$$

Result: More money in the

economy

Result: Less money in the

economy.(a) Open market purchase(expansionary):Fed buys governmentbonds with new dollars.

(b) Open market sale(contractionary):Fed exchanges governmentbonds for existing dollars.

Quantitative Easing is the targeted use of

open market operations in which the central bank buys securities in specific markets.

Quantitative Easing

Quantitative Easing, 2007–2014Beginning in 2008, the Federal Reserve began the unprecedented practice of quantitative easing (QE) to inject money into the economy. The QE initiatives were implemented when traditional monetary policy seemed to be failing to push the economy back to consistent growth.Source: GDP data is from the U.S. Bureau of Economic Analysis. QE data is from the Federal Reserve. Data quoted in 2009 dollars. 

Real GDP growth rate (quarterly)

6%4%2%0%-2%-4%-6%-8%-

10%

QE 1 announced:

$1.725 trillion intargeted

bondpurchases

2007 2008 2009 2010 2011 2012 2013 2014

QE 2announce

d:$600

billion inlong-termTreasury

bondpurchases

QE 3announced:$85 billion

inmortage-backed

and long-term

government

securities

Fed announcesend of QE 3

The Reserve Requirement is the amount of deposits that a bank must hold in reserve a determined by the central bank. This limits the amount of deposits a bank can lend.

2. Reserve Requirement and Discount Rates

The Discount Rate is the interest rate on discount loans made by the Federal Reserve to private banks.

Chapter 15 Observations:1. The Fed sets the ration of deposits that banks must hold on reserve. This ratio is the required reserve ratio (rr).2. The simple money multiplier (mm) depends on the required reserve ratio (rr), sincemm =1 /rr

2. Reserve Requirement and Discount Rates

Required Reserves and the Simple Money Multiplier

 rr mm

0.05 20

0.10 10

0.125 8

0.20 5

0.25 4

Decrease in rr Increase in mm

Increase in rr Decrease in mm

Fed would: (1) increase the discount rate to discourage borrowing

by banks and to decrease the money supply, or (2) decrease the discount rate to encourage borrowing

by banks and to increase the money supply.Currently, the Fed discourages discount borrowing unless

banks are struggling. Changing the discount rate to affect bank borrowing is no longer viewed as a helpful tool for changing the money supply.

Discount Rate The Discount Rate is the interest rate on discount loans made by the Federal Reserve to private banks.

Expansionary monetary policy occurs when a central bank acts to increase the money supply in an effort to stimulate the economy.

Contractionary monetary policy occurs when a central bank takes action that reduces the money supply in the economy.

Tools of the Fed and How They Affect the Money S u p p ly

Open m arke t ope ra tio ns

R es er v e re qu ire m ents

E x p a n s io n a r y

( in c re a se s money s u p p ly ) Buy bonds. Doing so puts fu n ds directly in the loanable fu n ds market, enabling banks to in crea se lending .

Decrease the reserve ratio so tha t banks may lend more of th e ir d e p o s its . Doing so e n a bles banks to inc reas e le nd in g .

C o n t ra c t io n a ry

(d e c r e a se s money s u p p ly ) Sell bonds. Doing so removes ba n k reserves that could have been lent in the loanable funds market, p re v e n t- ing banks from le nding .

Inc re as e the reserve ratio so tha t ba n ks cannot lend as many of the i r d e p o s its . Doing so limits banks’ lend - ing b eh a v io r.

Discount rate Decrease the rate, making it le ss

expensive to borrow from the F e d , thus s tim ula tin g len d in g .

Inc re as e the rate, making it m o r e expensive to borrow from the F e d , thus d isco ura g ing len din g .

Impact of Monetary Policy in Macroeconomy

1. The Fed uses open market operations to implement monetary policy. Open market operations involve the purchase or sale of bonds.

2. Government bonds are one important part of the loanable funds market (Chapter 14).

3. The price in the loanable funds market is the interest rate. Lower interest rates increase the quantity of investment demand, just as lower prices increase the quantity demanded in any product market (Chapter 14).

4. Investment is one component of GDP, so changes in investment lead to corresponding changes in GDP (Chapter 11).

5. In the short run, increases in aggregate demand increase output and lower the unemployment rate. Decreases in aggregate demand decrease output and increase the unemployment rate (Chapter 12).

Expansionary Monetary Policy in the Short Run(a) When the central bank buys bonds, it injects new funds directly into the loanable funds market. This action increases the supply of loanable funds (S1 shifts to S2) and decreases the interest rate from 5% to 3%. The lower interest rate leads to an increase in the quantity of investment demand (D) from $200 billion to $210 billion, which increases GDP. (b) The increase in aggregate demand (AD) causes real GDP to rise from $17.5 trillion to $18 trillion and reduces unemployment in the short run. The general price level rises to 105 (inflation).

Interest

rate

Price Level

(P)

5%3%

200 210 Loanable funds(billions of

dollars)(a) The Loanable Funds Market

Results summary GDP Unemployment Price level (P) Short run ↑ ↑

17.5 18

S2S1

D

105100

AD1AD2

Ab

Real GDP (trillions

of dollars)(b) Aggregate Demand and Aggregate Supply 

SRAS

Isn’t inflation a bad thing?Why would Fed want this?

Answer: Fed is weighing

the cost of continued low GDP and high unemployment against harm of higher prices. Usually the Fed iswilling to accept some inflation if it is offset by lower unemployment.

Real versus Nominal EffectsIf a central bank can stimulate real GDP and job creation by simply printing money, why would it ever stop? After all,fiat money is just paper.

The Real Value ofMoney as PricesAdjust(a) If the central bankincreases the money supplyat time t0, the pricelevel begins rising in theshort run. In the long run,all prices adjust and theprice level reaches itsnew higher level. (b) Asthe price level increases,the real value of moneydeclines throughout theshort run. In the long run,at tLR the real value ofmoney reaches a new lowerlevel.

Price level (P) 

Real value of money

(a) Adjusting Price Level

New moneyenters the economy Price level

Short run:prices adjusting

Long run:all prices nowadjusted

tLRt0 Time (t)

t0 tLR Time (t)

Long run: value reachesnew lower level

Short run: Value declining

Real value of money

(b) Changing Value of Money

Contractionary Monetary Policy in the Short Run(a) The central bank sells bonds, which pulls funds out of the loanable funds market. This action decreases the supply of loanable funds (S1 shifts to S2) and increases the interest rate from 5% to 6%. The higher interest rate leads to a decrease in investment from $200 billion to $190 billion, and this outcome decreases GDP. (b) The decrease in aggregate demand (from AD1 to AD2) as a result of lower investment causes real GDP to decline from $17.5 trillion to $17 trillion and increases unemployment in the short run. The general price level falls to 95 (a deflation).

Interestrate

6%5%

190 200 Loanable funds(billions of dollars

S1S2

D

Pricelevel

(P)

Results summary GDP Unemployment Price level (P) Short run 0 ↑ 0  

95100

SRAS

Ab

AD2AD1

(b) Real GDP (trillions of dollars)

(a) The Loanable Funds Market

17 17.5

What happens when all these people want to withdraw their funds?

PRACTICE WHAT YOU KNOWExpansionary versus ContractionaryMonetary Policy: Monetary Policy in the Short RunQuestion: How does expansionary monetary policy affect real GDP, unemployment, and the price level in the economy?Answer: Real GDP

increases, unemployment rate falls, and the price level rises.

Question: How does contractionary monetary policy affect real GDP, unemployment, and the price level in the economy?

Question: What real-world circumstance might lead to contractionary monetary policy?

Answer: Real GDP decreases, unemployment rate rises, and the price level falls.

Answer: If the Federal Reserve thought that inflation was an imminent danger, it might implement contractionary monetary policy.

Limitations of Monetary Policy

1.We look at the diminished effects of monetary policy in the long run.

2.We consider how expectations can dampen the effects of monetary policy.

3.We see that sometimes people don’t respond in a way that facilitates the Fed’s policies.

Long – Run AdjustmentsThe Long-Run is the period long enough or all prices to adjust, including wages and interestrates. In the long run, these resource prices will adjust. If everything works out well for you, the monetary expansion will lead to new demand for your product and you’ll be able to keep your new store open. But it’s also possible that after the prices of resources rise you may not be doing well enough to afford those resources. At that point, with your costs rising, you may have to reduce your output, lay off some workers, or perhaps even close your new store.In the long run, as prices adjust throughout the macroeconomy, the stimulating effects of expansionary monetary policy wear off.

Important Implications in the Long-runLack of real economic effects

from monetary policyPrices adjustMonetary policy does not affect

real GDP or unemploymentPrinting more money does not

affect the economy’s long run productivity or its ability to produce

Inflation is the only predictable result of more money in the economy over the long run

Monetary neutrality is the idea that the money supply does not affect real economic variables like real GDP or employment.Keynesian Perspective:Increase the money supply during economic downturns, and contract the money supply during economic expansions, because monetary policy can potentially smooth out the business cycle.Classical School of Thought:Discount the short-run expansionary effects of monetary policy, instead focus on the problems of inflation: uncertainty about future price levels, wealth distribution, and a devaluing of savings.

PRACTICE WHAT YOU KNOWMonetary Policy Isn’t Always Effective:Why Couldn’t Monetary Policy Pull Us Out of the Great Recession?The Great Recession officially lasted from December 2007 to June 2009. But the effects lingered on for several years thereafter, with slow growth of real GDP and high unemployment rates. These effects all occurred despite several doses of expansionary monetary policy. Not only did the Fed push short- term interest rates to nearly 0%, but it also engaged in several rounds of quantitative easing, in which it purchased hundreds of billions of dollars’ worth of long-term bonds.Question: What are the three possible reasons why monetary policy was not able to restore expansionary growth during and after the Great Recession?

Answer: Monetary policy is ineffective in the long run. While we don’t know the exactlength of the short run, prices certainly had time to adjust by 2010 or2011, yet the economy was still sluggish. Thus, one possibility is thatprices adjusted, so the effects of monetary policy wore off. This answeralone is probably inadequate, given that the effects of monetary policyweren’t evident even in the short run.

Answer: Monetary policy was expected. It seems unlikely that monetary policy is muchof a surprise nowadays. The Federal Reserve releases official statementsafter each monetary policy meeting and generally announces the direction itwill follow for the next several months.

Answer: People didn’t respond as the Fed had hoped. Households didn’t want toborrow, and banks were legally restricted in whom they could lend to.Without the cooperation of individuals and banks, the money supply didn’tincrease to the extent the Fed wanted, thus limiting the impact of monetarypolicy.

Answering the Big QuestionsWhat are tools of monetary policy?✷ The Fed has three tools to adjust the money supply: open market operations,the discount rate, and the reserve ratio. Of these tools, the only one used with regularity is open market operations.✷ An extreme version of open market operations is quantitative easing, or QE, which involves buying securities in specifically targeted markets.What is the effect of monetary policy in the short run?✷ Expansionary monetary policy can stimulate the economy in the short run, increasing real GDP and reducing the unemployment rate, despite the risk of higher inflation.✷ Contractionary monetary policy can slow the economy in the short run, which may help to reduce inflation. The trade-off is lower output and higher unemployment.Why doesn’t monetary policy always work?✷ Monetary policy fails to produce real effects under three different circumstances. First, monetary policy has no real effect in the long run, since all prices can adjust. Second, if monetary policy is fully anticipated, prices adjust (and monetary policy works only when some prices are slow to adjust). Finally, the behavior of individuals and banksmay not be in sync with the Fed’s goals.

Reference:Essentials of Economics (2016)Dirk Mateer, Lee Coppock