Chapter 33: Monetary Policy

Chapter 33: Monetary Policy

1.  Monetary policy consists of altering the economy’s money supplies to stabilize aggregate output, employment, and the price level. The three major tools of monetary policy and the effect on real GDP and price level. The three major tools of monetary policy include:

a)  Open market operations involves the buying and selling of government bonds (securities) by the Federal reserve Banks in the open market. Buying securities from banks and/or the public will increase bank reserves and thus the money supply. When the Fed buys government bonds the supply decreases, raising bond prices and lowering interest rates. Selling securities to banks and/or the public will decrease bank reserves and thus the money supply. When the Fed sells government bonds the supply increases, lowering bond prices and raising the interest rates.

b)  The reserve ratio: lowering the reserve ratio decreases the amount of required reserves banks must maintain increasing excess reserves and the money supply via new loans. Raising the reserve ratio increases the amount of required reserves banks must maintain decreasing excess reserves and the money supply.

c)  The discount rate is the interest rates the Fed charges commercial banks for loans. When the discount rate is decreased, commercial banks are encouraged to obtain additional reserves by borrowing from Fed Reserve Banks.

2.  A tight or contractionary monetary policy is an attempt by the Fed to lower the supply of money in order to reduce spending and control inflation whereas an easy or expansionary monetary policy is an attempt to increase the supply of money in order to encourage spending and increase aggregate demand and employment. See chart beside:

3.  The effectiveness of monetary policy depends upon the elasticity of the demand for money and the investment. The steeper (more elastic) the demand curve for money, the larger the effect of any change in the money supply on the equilibrium rate of interest. Furthermore, any change in the interest rate will have a larger impact on investment—and hence aggregate demand and GDP – the flatter (more elastic) the investment demand curve.

4.  The net export effect of monetary policy, unlike fiscal policy, will increase net exports if expansionary and decrease net exports if contractionary.