Section 3 Monetary Policy

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 -