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Lesson summary: monetary policy
In this lesson summary review and remind yourself of the key terms and graphs related to monetary policy. Topics include the tools of monetary policy, open market operations, as well as the newly added ample reserves banking system.
Lesson Summary
We learned in a previous lesson that governments use fiscal policy to close output gaps. But central banks also have a tool to smooth the business cycle: monetary policy. Most central banks have a dual mandate to maintain stable prices and to promote full employment. Central banks use the money supply to meet these two objectives. When a central bank changes the money supply, it changes interest rates, and changes in interest rates impact investment and aggregate demand.
Key Terms
| Key term | Definition |
|---|---|
| monetary policy | the use of the money supply to influence macroeconomic aggregates, such as output, inflation, and unemployment |
| dual mandate | the two objectives of most central banks, to 1) control inflation and 2) maintain full employment |
| contractionary monetary policy | monetary policy designed to decrease aggregate demand, decrease output, and increase unemployment |
| expansionary monetary policy | monetary policy designed to increase aggregate demand, increase output, and decrease unemployment; |
| open market operations | the buying and selling of securities, such as bonds, by a central bank to change the money supply |
| Federal Reserve | (nicknamed the “Fed”) the central bank of the United States of America; the Federal Reserve is responsible for maintaining the health of the financial system and conducting monetary policy. |
| discount rate | the name given to the interest rate that the Federal Reserve sets on loans that the Fed makes to banks; changing the discount rate is a tool of monetary policy, but it is not the primary tool that central banks use. |
| reserve ratio | the amount of reserves that banks are required to keep on hand by a central bank; changing the reserve ratio is a tool of monetary policy, but it is rarely changed and is rarely used to conduct monetary policy. |
| Fed Funds rate | the interest rate that banks charge each other for short-term loans; when the Federal Reserve changes the money supply, it changes the Fed Funds rate |
| interest on reserves (IOR) | interest on the deposits that commercial banks hold within the central bank |
Key Takeaways
The tools and outcomes of monetary policy
The table below summarizes the tools and outcomes of monetary policy:
| Recessionary gaps | Inflationary gaps | |
|---|---|---|
| Why | full employment | price stability |
| How | increase money supply | decrease the money supply |
| Tools used (primary tool in bold) | 1) open market purchases (buy bonds), 2) decrease discount rate, 3) decrease reserve ratio | 1) open market sales (sell bonds), 2) increase discount rate, 3) increase reserve ratio |
| Impact on interest rates | decrease nominal interest rate | increase the nominal interest rate |
| Impact on output | increase Y | decrease Y |
| Impact on unemployment | UR decreases | UR increases |
| Impact on price level/inflation | inflation increases | inflation decreases |
Monetary policy can be used to achieve macroeconomic goals
When there is macroeconomic instability, such as high unemployment or high inflation, monetary policy can be used to stabilize the economy. The goals and appropriate monetary policy can be summarized as shown in the table below:
| What the central bank might want to fix | The appropriate monetary policy for that fix |
|---|---|
| Output that is too low, unemployment that is too high, or inflation that is too low | expansionary monetary policy |
| Output that is too high, unemployment that is too low, or inflation that is too high | contractionary monetary policy |
The three traditional tools of monetary policy
Central banks usually have three monetary policy tools:
Open market operations: buying or selling bonds
Changing the discount rate: changing the rate that the central bank charges banks to borrow money
Changing the reserve requirement: changing how much money a bank must keep in reserves
Open market operations (“OMOs”) are the central bank’s primary tool of monetary policy. If the central bank wants interest rates to be lower, it buys bonds. Buying bonds injects money into the money market, increasing the money supply. When the central bank wants interest rates to be higher, it sells off bonds, pulling money out of the money market and decreasing the money supply.
More recently, the Federal Reserve has used a relatively new tool of monetary policy: interest on reserves (IOR). When the central bank pays interest on reserves, it encourages banks to keep more on reserve and lend less out, creating a banking system with ample reserves.
Banking systems with ample reserves
Before the 2008 financial crisis, the banking system operated differently than it does today. After 2008, commercial banks started holding a significant amount of reserves with the central bank due to stricter regulations and the introduction of interest payments on those reserves.
With ample reserves, commercial banks could deposit their extra money with the central bank and earn a safe and guaranteed interest, known as the interest on reserves rate (IOR).
How does this affect the demand for reserves?
Demand for reserves is inversely related to the federal funds rate. If the federal funds rate is high, commercial banks prefer to loan money out to other banks to earn higher returns. On the other hand, if the federal funds rate is low, banks are more inclined to deposit money with the central bank and earn IOR, instead.
In a banking system with limited reserves, changes in the money supply have a significant impact on interest rates and the overall economy. In a banking system with ample reserves, the tools of traditional monetary policy, such as open market operations, have limited effectiveness in influencing interest rates.
As a result, the central bank will adjust the interest rate on reserves to stimulate or slow down the economy. Lowering the interest rate on reserves encourages investment and increases aggregate demand, while increasing the interest rate on reserves decreases investment and consumer spending, leading to a decrease in aggregate demand.
Therefore, decreasing the IOR can be considered expansionary monetary policy and increasing the IOR can be considered contractionary monetary policy.
Open market operations change the monetary base, but the impact on the money supply is larger due to the money multiplier
When a central bank performs an open market operation, such as buying bonds, they pay for those bonds by depositing money into a bank’s reserves. For example, suppose that the central bank buys
Now the bank has
Instead, banks will make loans using that money. In fact, it can loan the entire
We can use the money multiplier to predict the maximum change in the money supply that will occur as a result of the OMO. If the money multiplier is 4, then the money supply will increase by up to
Central banks usually target overnight interbank lending rates with OMOs
Central banks might influence any number of rates directly. So what exactly is a central bank targeting?
Open market operations target the rate that banks charge other banks, usually for very short-term loans (such as over a single night). In the United States, this is called the Fed Funds rate. LIBOR is the overnight interbank rate in the U.K., and SHIBOR is the overnight interbank rate in Shanghai, China.
It might sound weird that a bank would want to borrow money from another bank, but it happens all the time. For example, sometimes banks have an unexpected withdrawal and fall below their required reserves. A bank could borrow money from another bank with excess reserves to meet that requirement. A bank might have a customer that wants to borrow money from it, but doesn’t have the excess reserves to do so. That bank can borrow money from another bank that does have excess reserves, and then make the loan to its customer.
Monetary policy influences aggregate demand, real output, the price level, and interest rates
Many central banks have a legal requirement to ensure price stability and full employment. This means that central banks use monetary policy to influence key variables like X and Y. We can summarize the impact monetary policy has on these variables as done in the table below:
| Monetary policy | effect on interest rates | effect on AD | effect on real output (Y) | effect on the price level (PL) | effect on unemployment |
|---|---|---|---|---|---|
| Expansionary monetary policy | n.i.r. ↓ | AD ↑ | Y ↑ | PL ↑ | UR ↓ |
| Contractionary monetary policy | n.i.r. ↑ | AD ↓ | Y ↓ | PL ↓ | UR ↑ |
The limitations of monetary policy
Monetary policy, like fiscal policy, suffers from lags that might hamper how effective it can be at closing an output gap. First of all, it takes time to recognize that there is a problem in the economy and react appropriately. Second, even if the interest rate changes quickly when OMOs are carried out, the impact of the interest rate change takes time.
Recall that OMOs impact the overnight rate. It takes time for changes in the overnight rate to pass through to other interest rates. Even once other interest rates have adjusted, the investment response to a new interest rate takes time
For example, suppose Inigo is thinking about buying a new home, but banks aren’t willing to lend any money right now because they are fully loaned out. Then, the central bank of Florin buys bonds, which increases the amount of funds available to loan out and decreases the interest rate banks charge each other.
Eventually, this changes the interest rate charged for home loans, too. Inigo sees that his local mortgage lender is offering lower interest rates. He takes out a loan and hires a builder to build his dream home. Only once he pays the builder will real GDP change.
Key Graphical Models
Figure 1 illustrates that when the central bank buys bonds, it increases the money supply. As a result of the increase in the money supply, the nominal interest rate will decrease.
Common misperceptions
- It might seem like a time-saver to skip steps when describing the chain of events involved in monetary policy, but taking an extra minute or two is worth it. If you want to save time, use abbreviations and arrows rather than skipping steps. For example, if you want to communicate this: “*An increase in the money supply will lower interest rates, which will increase investment and aggregate demand. As a result, output will increase, the price level will increase, and the unemployment rate will decrease.” You could write instead: “Ms ↑ → n.i.r. ↓ → I ↑ → AD ↑ → (Y ↑ PL ↑ UR ↓)”
- If a question asks you for an open market operation, you might think it’s a good idea to list all of the tools of monetary policy. This is not a good idea, because you haven’t answered the question that was asked and you won’t get any credit. Instead, only give an answer to the question you are asked so you get full credit.
Discussion questions
- The economy of Fredonia has experienced the demand shock shown here:
Part 1: Suppose the central bank wants to correct this gap. What is the appropriate open market operation? Explain.
Part 2: Show the impact of the OMO you chose on the money market
Part 3: Which curve in the AD-AS model would be impacted by this? How would it change? Explain.
Part 4: Would this cause the price level to increase, decrease, or stay the same? Explain.
Part 5: Would the unemployment rate increase, decrease, or stay the same? Explain.
Want to join the conversation?
how is it that unemployment increases when the demand curve decreases?(2 votes)
When aggregate demand decreases, output decreases. You need fewer workers to make less stuff, so whenever output decreases unemployment increases.(14 votes)
How do monetary policy and interest rates work together?(2 votes)- typically, they're opposites.
If the fed wants to increase the amount of money in an economy to attack a recession, the Fed would: buy bonds (this puts money into the economy), decrease the discount rate, or (which is unlikely), decrease the reserve requirements for banks. As a result, this would decrease the interest rates, as banking institutions are highly competitive and want the lowest interest rates possible, while still earning a profit.
If an economy is in an inflationary gap, the fed can: sell bonds (this takes the people's money), increase the discount rate, and increase the reserve requirement (which is, once again, unlikely). As a result, this would increase interest rates.(2 votes)
- briefly explain in simple terms the meaning of monetary policy transmission mechanism and then illustrate how changes in the interest rates impact business(2 votes)
Monetary policy transmission mechanism is a systemic process which incites a changes in the economy.
If interest rates are increased, banks will tend to borrow less money from the central bank, while trying to lend people more money. People will borrow less money from a banks, while trying to put their money in their bank accounts. Ultimately, this leads to lesser investments, lower inflation and economic stability.
However, this could lead to a deflation.
If interest rates are decreased, banks will tend to borrow more money from the central bank. People will borrow more money from a banks. Ultimately, this leads to more consumption and investments, higher inflation and economic boom with the risk of bubble or debt cycles.(1 vote)
- "Remember that money in vaults is counted as part of the monetary base, but not as part of the money supply." This and other references to money in vaults in this course confuses me. Can't one keep demand deposits in the vault, and is that not part of the money supply? Moreover other sites seem to be at odds with this description. For example, Investopedia comments, "This measure of the money supply typically only includes the most liquid currencies; it is also known as the "money base."(2 votes)
For part 3: Could both the supply and demand curves decrease? If interest rates are higher, could that be considered a higher input cost for firms, which would therefore decrease supply?(2 votes)- For a few, maybe. However, this wouldn't shift the supply curve. High interest rates wouldn't be considered a high input cost for a majority of the firms, only those who are looking for loans, mostly.(0 votes)
Why is full employment the 'why' to recessionary gaps?(1 vote)- Its not rlly the "why" its the problem (high unemployment) caused by recessionary gaps that monetary policy wants to fix (by reaching full employment)(1 vote)
- Does monetary policy also affect real interest rate? Would it shift the supply or demand curve of the loanable funds graph?(1 vote)
So decreasing the discount rate to a rate lower than the funds rate will encourage banks to lend out more money because the banks can borrow money from the fed at a cheaper cost. Thus, when they lend out more money, the money supply grows shifting Ms to the right?(1 vote)
How does fiscal policy shift the aggregate supply curve?(1 vote)
Expansionary policy shifts the AD curve to the right, while contractionary policy shifts it to the left.(1 vote)
If the Fed sells bonds equal to 0.3% of GDP in its Open Market Operations, and as a result GDP increases by 2%, will interest rates increase by 1.7%?(1 vote)
