Section 3 Monetary Policy The Fed’s Monetary Tools

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

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

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

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

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 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

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

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

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

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%

Chapter 16 Section 4

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

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

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

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

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

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

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

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?

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 -