1. Section 3 Monetary Policy
The Fed’s Monetary Tools

2. Approaches to Monetary Policy
Policy 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

3. 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 rate
most common action is to sell bonds to raise interest rates

5. Alan Greenspan: Fighting Inflation
Managing Monetary Policy
Greenspan served as chair of Fed’s Board of Governors over 18 years
his insight and persuasiveness made him extremely influential

6. Alan Greenspan: Fighting Inflation
Was very successful at growing economy without inflation
great knowledge of tools of monetary policy and economic indicators
sense of timing: knew just when to expand or contract money supply

7. 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

8. Impacts and Limitation of Monetary Policy
Impact 1: Short-Term Effects
The short-term effect is a change in the price of credit
Open market operations influence FFR fairly quickly
change loanable reserves banks have
Easy-money policy lowers interest rates; tight- money raises them

9. Impacts and Limitation of Monetary Policy
Impact 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 economy
example: businesses may delay expansion until interest rates drop

10. Impacts and Limitation of Monetary Policy
Impact 3: Timing Issues
Monetary policy must be coordinated with business cycle for stability
bad 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 supply
little or no inflation when money supply growth slow and steady

11. Impacts and Limitation of Monetary Policy
Other Issues
Monetary policy more effective if coordinated with fiscal policy
Goals of Fed may clash with those of Congress or President
governors serve 14 years; have less political pressure than politicians

12. Questions
Which 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%

13. Chapter 16 Section 4

14. Applying Monetary and Fiscal Policy
Fiscal and monetary policies impact each other
Both have limitations: policy lags, political constraints, timing issues
timing also affected by people’s actions based on rational expectations
Opponents of discretionary policy favor a stable monetary policy
thus people, businesses will not make decisions ahead of policies

15. 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 them
actual change in rates depends on relative strength of the two policies
amount of investment spending depends on rates

17. Policies to Control Inflation
Goal of contractionary monetary policy is to stabilize economy
decrease inflation and increase interest rates

18. Policies to Control Inflation
Example: Contractionary Monetary and Fiscal Policy
Contractionary policies decrease aggregate demand, control inflation
Fiscal policy lowers interest rates; monetary policy raises them
actual change in rates depends on relative strength of the two policies
amount of investment spending depends on rates

20. Policies to Control Inflation
Example: Wage and Price Controls
Government may establish non-mandatory wage and price guidelines
Wage and price controls—limits on increases in wages and prices
mandatory and enforced by government
WWII: President Roosevelt used to control inflation due to shortages
1970s: President Nixon used to try to combat stagflation

21. Policies in Conflict
Coordinated policies usually produce desired effect on economy
If uncoordinated, one policy can counter effects of the other
creates economic instability

22. Policies in Conflict Example: Conflicting Monetary and Fiscal Policies
Example: CPI is 6% and rising; unemployment is 7%
Fed tries to fix inflation by selling bonds, raising discount rate
government tries to lower unemployment by cutting taxes, more spending
Only clear result of conflicting policies is higher interest rates

24. Interpreting Signals from the Fed
Background
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 Issue
How 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?

25. Questions
What 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 -