CHAPTER 3 Monetary Policy

Expansionary Monetary Policy Increases the money supply or money growth rate and reduces interest rates. Open Market Purchase: purchase securities from banks and increase bank reserves and the monetary base. Discount Operations: reduce the discount rate and the cost of borrowing reserves. Reserve Requirements: reduce reserve requirements and increase excess reserves and deposit expansion.

Contractionary Monetary Policy Decreases the money supply or money growth rate and raises interest rates. Open Market Sale: sell securities to banks, and reduce bank reserves and the monetary base. Discount Operations: increase the discount rate and the cost of borrowing reserves. Reserve Requirements: increase reserve requirements and reduce excess reserves and deposit expansion.

Changes in the Money Supply When the Federal Reserve increases the monetary base as a result of an open market purchase, banks’ excess reserves increase. Excess reserves are loaned out or invested in securities. Demand deposits increase as loaned or invested funds are deposited. The money supply increases.

Changes in Interest Rates When the Federal Reserve increases the monetary base as a result of an open market purchase, banks’ excess reserves increase. The supply of funds in the federal funds market increases and the federal funds rate declines. Interest rates on loans decline with the increase in bank liquidity. Monetary policy starts in the federal funds market and spreads to other financial markets and institutions (banks) and to the rest of the economy.

Effects of Monetary Policy on the Economy Monetary policy affects investment spending as: Residential Investment: Housing investment is sensitive to changes in mortgage rates and credit availability. Non-Residential Fixed Invest: Plant and equipment investment is related to expected rates of return relative to the cost of financing. Inventory Investment: Planned inventory investment is sensitive to the cost and availability of credit.

Effects of Monetary Policy on the Economy Monetary policy affects consumption spending as: Changes in interest rates and credit availability affect the purchase of durable goods (big-ticket items). Increased or decreased holdings of money affect consumption spending.

Effects of Monetary Policy on the Economy Monetary policy affects international trade as: Higher domestic interest rates attract funds from abroad and increase the value of the domestic currency relative to other currencies. Higher domestic currency value encourages imports and discourages exports.

Change in the Money Supply, Interest Rates and the Economy

How Effective is Monetary Policy? Time lags in the transmission of monetary policy actions may reduce their effectiveness. Inflation expectations may offset the intended effects of monetary policy actions. High money growth rate to stimulate the economy may increase interest rates as: Markets expect higher inflation from current monetary policy action. Investors sell long-term bonds → prices fall and interest rates increase.