Econ: Monetary Policy

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.

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.


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