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Monetary Policy

Monetary policy is essential for stabilizing the economy. Expansionary policies increase the money supply, lower interest rates, and encourage borrowing and spending, boosting exports and economic growth. Conversely, contractionary policies raise interest rates and decrease money supply to curb inflation, even at the expense of jobs. Key instruments include the discount rate and the federal funds rate, influenced by central bank operations. Understanding the dynamics of these rates and the scarcity of reserves is crucial for comprehending how monetary policy impacts purchasing power and overall economic health.

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Monetary Policy

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Presentation Transcript

  1. Monetary Policy A Powerful Tool for Economic Stabilization

  2. Definitions • Expansionary: Increase in the growth rate of H and therefore of the money supply • Contractionary: The reverse

  3. Why Expansion? • Monetary expansion => increase in supply of money => lower value of money in the form of lower interest rates and exchange rate depreciation • Businesses & consumers borrow more & spend more • Exports rise, imports fall

  4. Why Contraction? • Monetary contraction does the opposite: interest rates up, the exchange value of the currency rises • Spending falls, but that will slow inflationary tendencies even at the cost of jobs

  5. A Tale of Two Interest Rates • The discount rate: the rate at which the central bank lends reserves directly to commercial banks • The federal funds rate: the rate at which commercial banks lend reserves to each other • These rates, particularly the FF rate, are the ones Greenspan raises or lowers when monetary policy changes

  6. Open Market Operations • News: Greenspan raised rates (Last week). What does that mean? • G’span sold securities to commercial banks (OMO); they paid by giving up reserves to the FED (US central bank)

  7. Scarce Reserves • Reserves are now scarcer; anything scarcer is more valuable • The federal funds rate is a market rate; scarcity of reserves, the thing traded, induces higher prices (ff rate) • That’s all he did!

  8. Reserves • The scarcity of reserves, that R in the equations and accounts, may be only relative (slower growth rate), but remains a powerful mover • The entire money supply will grow more slowly

  9. Why is this Important? • M, the money stock, is a store of potential purchasing power • It also has power as potential savings • It is always sitting somewhere, in someone’s pocket or bank account, just waiting to be used

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