APMacro: Monetary Policy

Monetary Tools
The Fed has a number of monetary tools available to change the money supply and interest rates to affect real output, employment, and price levels.

Open market operations are the most frequently used tool of monetary policy because of their flexibility and immediate effects. Open market operations are the Fed’s purchases and sales of government bonds with member banks and the public. When the Fed buys bonds from a bank, it creates reserves in the bank’s deposit with the Fed, which the bank can then lend to customers. When the Fed buys bonds from the public, it puts a check in the hand of the consumer, who can deposit the funds in his bank. The two transactions are slightly different in effect, because the bank can loan the full excess reserves resulting from its sale of bonds to the Fed, but the bank must keep the required reserves from the customer’s deposit, leading to a smaller increase in the money supply. In either case, the Fed increases the money supply when it buys bonds, and it reduces the money supply when it sells bonds.

The reserve requirement is the most powerful tool of monetary policy, so it is only rarely used. A change in the percentage of deposits the banks must hold in reserve directly impacts the bank’s ability to increase loans and, therefore, the money multiplier. If the Fed increases the reserve requirement, banks cannot loan as much and the money supply falls. A reduction in the reserve requirement increases the potential growth of the money supply.

A third important tool of monetary policy is the discount rate, which is the interest rate the Fed charges member banks for loans. A reduction in the discount rate encourages banks to borrow from the Fed and, in turn, increase loans to their customers. As a result, the money supply increases. An increase in the discount rate discourages banks from borrowing from the Fed, reducing loans and the money supply.

The Fed uses expansionary monetary policy or easy money policy to expand the money supply during recessions. A decrease in the reserve requirement, a lower discount rate, or the Fed’s purchase of securities can achieve this result. As the money supply grows and interest rates fall. The increase in demand results in an increase in real GDP, employment, and price levels.

Contractionary or tight money policy is used to reduce the money supply during periods of significant inflation. An increase in the reserve requirement, an increase in the discount rate, or the Fed’s sale of securities will reduce the money supply, increasing interest rates. As a result, real output will fall back to full-employment output and employment will fall. Because of the ratchet effect, however, prices are unlikely to decline.

Monetary policy holds advantages over fiscal policy in that monetary policy is very flexible and can be implemented quickly. Its policymakers are shielded from political pressure, allowing them to focus solely on what is good for short-run stabilization and long-run growth of the economy. But monetary policy also faces limitations on its effectiveness. It takes some length of time to recognize economic instability and to fully implement the monetary policies. But more importantly, while monetary policy works well to discourage borrowing during periods of inflation, it is not as effective in promoting investment during severe recessions. Firms consider return on investment as the benefit of investing, and when they have excess capacity as a result of lower consumer demand, they have little reason to invest even when interest rates are low. Banks may hesitate to make loans to firms that may close or households that may fall into foreclosure or bankruptcy, fearing the loans may not be repaid.

The total demand for money is determined by horizontally adding the asset demand for money to the transactions demand. The transactions demand is vertical because it is assumed to depend on nominal GDP rather than on the interest rate. The asset demand varies inversely with the interest rate because of the opportunity cost involved in holding currency and checkable deposits that pay no interest or very low interest. Combining the money supply with the total money demand portrays the market for money and determines the equilibrium interest rate.

1) Read Chapter 14 pp.259-271



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