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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 termDefinition
monetary policythe use of the money supply to influence macroeconomic aggregates, such as output, inflation, and unemployment
dual mandatethe two objectives of most central banks, to 1) control inflation and 2) maintain full employment
contractionary monetary policymonetary policy designed to decrease aggregate demand, decrease output, and increase unemployment
expansionary monetary policymonetary policy designed to increase aggregate demand, increase output, and decrease unemployment;
open market operationsthe 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 ratethe 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 ratiothe 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 ratethe 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 (Y<Yf and UR>URn)Inflationary gaps (Y>Yf and UR<URn)
Whyfull employmentprice stability
Howincrease money supplydecrease the money supply
Tools used (primary tool in bold)1) open market purchases (buy bonds), 2) decrease discount rate, 3) decrease reserve ratio1) open market sales (sell bonds), 2) increase discount rate, 3) increase reserve ratio
Impact on interest ratesdecrease nominal interest rateincrease the nominal interest rate
Impact on outputincrease Ydecrease Y
Impact on unemploymentUR decreasesUR increases
Impact on price level/inflationinflation increasesinflation 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 fixThe appropriate monetary policy for that fix
Output that is too low, unemployment that is too high, or inflation that is too lowexpansionary monetary policy
Output that is too high, unemployment that is too low, or inflation that is too highcontractionary 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 $1,000 worth of bonds. The central bank then increases bank’s reserve balances by $1,000. Remember that money in vaults is counted as part of the monetary base, but not as part of the money supply.
Now the bank has $1,000 in excess reserves. Central banks either pay no interest on those reserves, or they pay such a low interest rate that makes it not worthwhile to a bank to keep excess reserves. That means a bank will usually not want to leave money idle in bank vaults unless it absolutely has to.
Instead, banks will make loans using that money. In fact, it can loan the entire $1,000 because the $1,000 is not part of a demand deposit liability. As soon as it makes the loan, the money is now in circulation and is counted in M1.
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 $4,000.

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 policyeffect on interest rateseffect on ADeffect on real output (Y)effect on the price level (PL)effect on unemployment
Expansionary monetary policyn.i.r. ↓AD ↑Y ↑PL ↑UR ↓
Contractionary monetary policyn.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: Expansionary monetary policy in the money market
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?

  • leaf green style avatar for user Marilynmc09
    how is it that unemployment increases when the demand curve decreases?
    (2 votes)
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  • blobby green style avatar for user Zodwa Mchunu
    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)
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    • piceratops ultimate style avatar for user Hyun Bin Lee
      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)
  • blobby green style avatar for user earl kraft
    "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)
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  • spunky sam blue style avatar for user Cole.Rees
    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)
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  • duskpin ultimate style avatar for user Cindy Wang
    Why is full employment the 'why' to recessionary gaps?
    (1 vote)
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  • blobby green style avatar for user Kevin Sony
    Does monetary policy also affect real interest rate? Would it shift the supply or demand curve of the loanable funds graph?
    (1 vote)
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  • blobby green style avatar for user Sunny Smith
    How do monetary policy and interest rates work together?
    (1 vote)
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    • blobby green style avatar for user Davoid Coinners
      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.
      (1 vote)
  • leaf blue style avatar for user Islam,Sumaia
    How does fiscal policy shift the aggregate supply curve?
    (1 vote)
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  • duskpin tree style avatar for user Anahita Asudani
    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)
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  • blobby green style avatar for user Billie Patterson
    Fredonia can lower interest rates or increase spending to correct a demand shock. Buying bonds increases the money supply. They could decrease the discount rate or decrease the reserve ratio. AD would be affected. It would increase GDP. It would encourage full employment. However it would increase inflation or the price level.
    (1 vote)
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