Topic 4.6 Notes – Monetary Policy

1. What Monetary Policy Is

Monetary policy means actions by a central bank, in the U.S. the Federal Reserve, to influence interest rates, the money supply, and overall economic activity.

Main goals

• Price stability (low, stable inflation)
• Full employment (real GDP at potential output)
• Financial system stability

The Fed mainly influences the nominal interest rate in the short run. That rate affects:

• Investment (I)
• Interest-sensitive consumption (C)
• Aggregate demand (AD)
• Real output (Y) and the price level (PL)

Two policy stances

• Expansionary (easy) monetary policy
  Used in a recessionary gap to increase AD.
• Contractionary (tight) monetary policy
  Used in an inflationary gap to decrease AD.

Today, the U.S. operates in an ample reserves system, so the Fed primarily targets a range for the federal funds rate using interest on reserves (IOR) and other administered rates.

2. The Tools of Monetary Policy

You need to know how each tool affects reserves, the monetary base, the money supply, and interest rates.

A. Open Market Operations (OMO)

Buying and selling government bonds.

• Open-market purchase
  • Fed buys bonds
  • Bank reserves ↑
  • Monetary base ↑
  • In a limited reserves system → money supply ↑ (multiplier effect)
  • Nominal interest rate ↓
• Open-market sale
  • Fed sells bonds
  • Bank reserves ↓
  • Monetary base ↓
  • Money supply ↓
  • Nominal interest rate ↑

In a limited reserves system, the change in money supply is larger than the change in the monetary base because of the money multiplier.

B. Federal Funds Rate and Interest on Reserves

The federal funds rate is the overnight rate banks charge each other for reserves. The Fed sets a target range for it.

• In a limited reserves system, changing the money supply shifts the federal funds rate.
• In an ample reserves system (current U.S.), the Fed adjusts:
  • Interest on reserves (IOR)
  • Other administered rates

These rates influence banks’ lending behavior and effectively set a floor under the federal funds rate.

C. Discount Rate

The discount rate is the interest rate the Fed charges banks to borrow directly from it.

• Lower discount rate → banks borrow more → reserves ↑ → money supply ↑
• Higher discount rate → borrowing ↓ → reserves ↓ → money supply ↓

It’s less commonly used today but still testable.

D. Required Reserve Ratio

The required reserve ratio (RRR) is the fraction of deposits banks must hold.

$$\text{Money Multiplier} = \frac{1}{\text{RRR}}$$

If RRR = 0.20, multiplier = 5.

Example:
If the Fed conducts a 50 billion dollar open-market purchase and RRR = 0.10:

• Multiplier = 10
• Max increase in money supply = 50 billion × 10 = 500 billion

This large expansion only applies in a limited reserves system.

3. How Monetary Policy Affects the Economy

You should be able to show this in the money market and the AD-AS model.

Expansionary Policy (Recessionary Gap)

Chain reaction:

1. Fed increases reserves or lowers policy rate
2. Nominal interest rate ↓
3. Investment ↑
4. AD shifts right
5. Real GDP ↑, PL ↑

On an AD-AS graph, expansionary policy shifts aggregate demand from AD₁ to AD₂, moving the economy to a higher level of real GDP and a higher price level.

Expansionary monetary policy in the AD-AS model

Real-world anchor:
During the 2008-2009 financial crisis, the Fed cut rates near zero and used quantitative easing (large-scale bond purchases) to stimulate AD.

Contractionary Policy (Inflationary Gap)

1. Fed decreases reserves or raises policy rate
2. Nominal interest rate ↑
3. Investment ↓
4. AD shifts left
5. Real GDP ↓, PL ↓

Graphically, this is the opposite shift. Aggregate demand moves left, lowering real GDP and the price level in the short run.

Real-world anchor:
In the early 1980s, Paul Volcker raised interest rates sharply to fight high inflation, triggering a recession but reducing inflation.

Monetary policy also affects exchange rates through capital flows. Higher U.S. interest rates attract foreign capital, increasing demand for dollars and causing appreciation.

4. Calculating the Effects

In FRQs, you may use T-accounts and multiplier math.

Open-market purchase in a limited reserves system:

• Assets (bonds) ↑ at Fed
• Reserves ↑ at banks
• Loans ↑
• Deposits ↑
• Money supply expands by multiplier

Always track:

• Reserves
• Monetary base
• Money supply
• Interest rate direction

5. Why There Are Lags

Monetary policy is not instant.

• Recognition lag
  Time to detect recession or inflation (data is delayed and revised).
• Impact lag
  Time for rate changes to affect borrowing, spending, and AD.

Monetary policy has a shorter implementation lag than fiscal policy, but the impact lag still matters. Poor timing can cause the economy to overshoot.