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Monetary Policy

Monetary Policy. A Powerful Tool for Economic Stabilization. Definitions. Expansionary: Increase in the growth rate of H and therefore of the money supply Contractionary: The reverse. Why Expansion?.

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Monetary Policy

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  1. Monetary Policy A Powerful Tool for Economic Stabilization

  2. Definitions • Expansionary: Increase in the growth rate of H and therefore of the money supply • Contractionary: The reverse

  3. Why Expansion? • Monetary expansion => increase in supply of money => lower value of money in the form of lower interest rates and exchange rate depreciation • Businesses & consumers borrow more & spend more • Exports rise, imports fall

  4. Why Contraction? • Monetary contraction does the opposite: interest rates up, the exchange value of the currency rises • Spending falls, but that will slow inflationary tendencies even at the cost of jobs

  5. A Tale of Two Interest Rates • The discount rate: the rate at which the central bank lends reserves directly to commercial banks • The federal funds rate: the rate at which commercial banks lend reserves to each other • These rates, particularly the FF rate, are the ones Greenspan raises or lowers when monetary policy changes

  6. Open Market Operations • News: Greenspan raised rates (Last week). What does that mean? • G’span sold securities to commercial banks (OMO); they paid by giving up reserves to the FED (US central bank)

  7. Scarce Reserves • Reserves are now scarcer; anything scarcer is more valuable • The federal funds rate is a market rate; scarcity of reserves, the thing traded, induces higher prices (ff rate) • That’s all he did!

  8. Reserves • The scarcity of reserves, that R in the equations and accounts, may be only relative (slower growth rate), but remains a powerful mover • The entire money supply will grow more slowly

  9. Why is this Important? • M, the money stock, is a store of potential purchasing power • It also has power as potential savings • It is always sitting somewhere, in someone’s pocket or bank account, just waiting to be used

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