Section 3 Monetary Policy

The Fed’s Monetary Tools

Approaches to Monetary PolicyPolicy 1: Expansionary Policy

Expansionary monetary policy also called easy-money policy

In recession, Fed increases money supply to increase aggregate demand

Fed can buy bonds on open market, decrease RRR or discount rate most common practice is to buy bonds

to make interest rates fall

Approaches to Monetary Policy

Policy 2: Contractionary Policy Tight-money policy is another name for contractionary monetary policy

Fed decreases money supply to check aggregate demand, inflation

Fed can sell bonds on open market, increase RRR or discount ratemost common action is to sell bonds to

raise interest rates

Alan Greenspan: Fighting Inflation

Managing Monetary PolicyGreenspan served as chair of Fed’s Board of Governors over 18 yearshis insight and

persuasiveness made him extremely influential

Alan Greenspan: Fighting Inflation

Was very successful at growing economy without inflationgreat knowledge of

tools of monetary policy and economic indicators

sense of timing: knew just when to expand or contract money supply

Impacts and Limitation of Monetary Policy

Purposes of monetary policy—curb inflation and halt recessions

Changes in monetary policy have both short-term and long-term effects

Impacts and Limitation of Monetary PolicyImpact 1: Short-Term Effects

The short-term effect is a change in the price of credit

Open market operations influence FFR fairly quicklychange loanable reserves banks have

Easy-money policy lowers interest rates; tight-money raises them

Impacts and Limitation of Monetary PolicyImpact 2: Policy Lags

Delays in getting information to identify problems delays Fed action

Policy adjustments may take a long time to take effect in the economyexample: businesses may delay

expansion until interest rates drop

Impacts and Limitation of Monetary Policy

Impact 3: Timing IssuesMonetary policy must be coordinated with business cycle for stabilitybad timing may exaggerate a phase of the

business cycle Monetarism holds that rapid changes in money supply cause instability Milton Friedman found inflation goes with rapid

growth in money supplylittle or no inflation when money supply growth

slow and steady

Impacts and Limitation of Monetary PolicyOther Issues

Monetary policy more effective if coordinated with fiscal policy

Goals of Fed may clash with those of Congress or Presidentgovernors serve 14 years; have less

political pressure than politicians

QuestionsWhich open market operation causes the

money supply to expand? Why? Compare and contrast expansionary fiscal

policy and expansionary monetary policy on the chart below.

What will happen to interest rates when the Fed sells bonds in open market operations? Why?

What are the Fed’s underlying assumptions about the state of the economy, based on these Fed actions?The Fed’s open market operations caused the FFR

to drop from 6.25% to 1%.The FFR rose from 1% to 4.2%

Chapter 16 Section 4

Fiscal and monetary policies impact each other

Both have limitations: policy lags, political constraints, timing issuestiming also affected by people’s

actions based on rational expectations Opponents of discretionary policy favor

a stable monetary policythus people, businesses will not make

decisions ahead of policies

Applying Monetary and Fiscal Policy

Policies to Expand the Economy

Example: Expansionary Monetary and Fiscal Policy Expansionary policy meant to reduce unemployment, increase investment

Expansionary fiscal policy raises interest rates; monetary lowers themactual change in rates depends on

relative strength of the two policiesamount of investment spending depends

on rates

Policies to Control InflationGoal of contractionary monetary

policy is to stabilize economydecrease inflation and increase

interest rates

Policies to Control InflationExample: Contractionary Monetary

and Fiscal PolicyContractionary policies decrease aggregate demand, control inflation

Fiscal policy lowers interest rates; monetary policy raises themactual change in rates depends on

relative strength of the two policiesamount of investment spending

depends on rates

Policies to Control Inflation

Example: Wage and Price ControlsGovernment may establish non-

mandatory wage and price guidelines Wage and price controls—limits on

increases in wages and pricesmandatory and enforced by governmentWWII: President Roosevelt used to control

inflation due to shortages1970s: President Nixon used to try to

combat stagflation

Policies in ConflictCoordinated policies usually

produce desired effect on economyIf uncoordinated, one policy can

counter effects of the othercreates economic instability

Policies in Conflict

Example: Conflicting Monetary and Fiscal PoliciesExample: CPI is 6% and rising; unemployment is 7%Fed tries to fix inflation by selling bonds,

raising discount rategovernment tries to lower unemployment

by cutting taxes, more spendingOnly clear result of conflicting policies is higher interest rates

Interpreting Signals from the FedBackground

Economists and financial observers scrutinize everything the Fed chairman says in an attempt to predict how his statements will affect the economy. A hint that the Fed might change interest rates can lead to a great deal of activity in the stock market.

What’s the IssueHow much does the market rely on signals from the Fed

to make economic decisions?Thinking Economically

How do articles A and C illustrate the rational expectations theory?

Based on these three sources and your own knowledge, how would you describe the differences and similarities between Greenspan and Bernanke and their impact on the market?

QuestionsWhat effects would government borrowing

to finance increased spending have on interest rates and why?

Why do tax cuts and increased government spending result in a rise in interest rates?

What are the results of each of the following?Expansionary Policies -Contractionary Policies -Conflicting Policies -