Lesson Summary
We learned in a previous lesson that governments use fiscal policy to close output gaps. But central banks also have a tool to smooth the business cycle: monetary policy. Most central banks have a dual mandate to maintain stable prices and to promote full employment. Central banks use the money supply to meet these two objectives. When a central bank changes the money supply, it changes interest rates, and changes in interest rates impact investment and aggregate demand.
Key Takeaways
The tools and outcomes of monetary policy
The table below summarizes the tools and outcomes of monetary policy:
| Recessionary gaps | Inflationary gaps | |
|---|---|---|
| Why | full employment | price stability |
| How | increase money supply | decrease the money supply |
| Tools used (primary tool in bold) | 1) open market purchases (buy bonds), 2) decrease discount rate, 3) decrease reserve ratio | 1) open market sales (sell bonds), 2) increase discount rate, 3) increase reserve ratio |
| Impact on interest rates | decrease nominal interest rate | increase the nominal interest rate |
| Impact on output | increase Y | decrease Y |
| Impact on unemployment | UR decreases | UR increases |
| Impact on price level/inflation | inflation increases | inflation decreases |
Monetary policy can be used to achieve macroeconomic goals
When there is macroeconomic instability, such as high unemployment or high inflation, monetary policy can be used to stabilize the economy. The goals and appropriate monetary policy can be summarized as shown in the table below:
| What the central bank might want to fix | The appropriate monetary policy for that fix |
|---|---|
| Output that is too low, unemployment that is too high, or inflation that is too low | expansionary monetary policy |
| Output that is too high, unemployment that is too low, or inflation that is too high | contractionary monetary policy |
The three traditional tools of monetary policy
Central banks usually have three monetary policy tools:Open market operations: buying or selling bondsChanging the discount rate: changing the rate that the central bank charges banks to borrow moneyChanging the reserve requirement: changing how much money a bank must keep in reserves
Open market operations (“OMOs”) are the central bank’s primary tool of monetary policy. If the central bank wants interest rates to be lower, it buys bonds. Buying bonds injects money into the money market, increasing the money supply. When the central bank wants interest rates to be higher, it sells off bonds, pulling money out of the money market and decreasing the money supply.
Sure! Let’s use the nation of Theopolis as an example. There are two banks in Theopolis (let’s call them Bank #1 and Bank #2) and a central bank. The reserve requirement is 10%, and both of the banks are fully loaned out (in other words, neither bank has any excess reserves).
If Theopolis is currently in a recession, the central bank wants to close that gap to decrease unemployment. It can do that by encouraging investment. Recall that investment is spending by firms, so this includes things like building new factories or expanding production facilities. But, the banks don’t have any excess reserves to loan out!
The solution is that the central bank steps in. They buy a short-term bond that costs
Where did that
More recently, the Federal Reserve has used a relatively new tool of monetary policy: interest on reserves (IOR). When the central bank pays interest on reserves, it encourages banks to keep more on reserve and lend less out, creating a banking system with ample reserves.
Banking systems with ample reserves
Before the 2008 financial crisis, the banking system operated differently than it does today.
Commercial banks held very few reserves with the central bank and instead lent that money to customers or other banks. This system, known as a banking system with limited reserves, had a notable effect on interest rates when there was a small change in the money supply.
After 2008, commercial banks started holding a significant amount of reserves with the central bank due to stricter regulations and the introduction of interest payments on those reserves.
With ample reserves, commercial banks could deposit their extra money with the central bank and earn a safe and guaranteed interest, known as the interest on reserves rate (IOR).
How does this affect the demand for reserves?
Demand for reserves is inversely related to the federal funds rate. If the federal funds rate is high, commercial banks prefer to loan money out to other banks to earn higher returns. On the other hand, if the federal funds rate is low, banks are more inclined to deposit money with the central bank and earn IOR, instead.
In a banking system with limited reserves, changes in the money supply have a significant impact on interest rates and the overall economy. In a banking system with ample reserves, the tools of traditional monetary policy, such as open market operations, have limited effectiveness in influencing interest rates.
As a result, the central bank will adjust the interest rate on reserves to stimulate or slow down the economy. Lowering the interest rate on reserves encourages investment and increases aggregate demand, while increasing the interest rate on reserves decreases investment and consumer spending, leading to a decrease in aggregate demand.
Therefore, decreasing the IOR can be considered expansionary monetary policy and increasing the IOR can be considered contractionary monetary policy.
Open market operations change the monetary base, but the impact on the money supply is larger due to the money multiplier
When a central bank performs an open market operation, such as buying bonds, they pay for those bonds by depositing money into a bank’s reserves. For example, suppose that the central bank buys
Now the bank has
Instead, banks will make loans using that money. In fact, it can loan the entire
We can use the money multiplier to predict the maximum change in the money supply that will occur as a result of the OMO. If the money multiplier is 4, then the money supply will increase by up to
Central banks usually target overnight interbank lending rates with OMOs
Central banks might influence any number of rates directly. So what exactly is a central bank targeting?
Open market operations target the rate that banks charge other banks, usually for very short-term loans (such as over a single night). In the United States, this is called the Fed Funds rate. LIBOR is the overnight interbank rate in the U.K., and SHIBOR is the overnight interbank rate in Shanghai, China.
It might sound weird that a bank would want to borrow money from another bank, but it happens all the time. For example, sometimes banks have an unexpected withdrawal and fall below their required reserves. A bank could borrow money from another bank with excess reserves to meet that requirement. A bank might have a customer that wants to borrow money from it, but doesn’t have the excess reserves to do so. That bank can borrow money from another bank that does have excess reserves, and then make the loan to its customer.
The Federal Reserve System (“the “Fed”), has a special committee called the federal open market committee (FOMC). This committee meets at least eight times a year to discuss the economy and set a target interest rate based on how the economy is doing. In March of 2001, the economy was in a recession. The FOMC decided to lower interest rates by half a percent from 5% to 4.5%.
When the Fed decides to lower interest rates, they instruct the trading desk at the Fed’s New York branch to buy bonds. When the Fed buys bonds, they pay for them by depositing money into a bank’s reserve account at the Fed.
You might recall that a bank must keep a certain amount in reserve at the Fed, but the bank won’t earn any interest on those reserves. So, if a bank’s reserve balance increases, the bank will want to put that money to use quickly. The most direct approach is to loan it to other banks. By loaning that money, banks increase the money supply and lowers the interest rate called the Fed Funds rate (the interest rate that banks charge each other for loans). The Fed Funds rate influences other interest rates in the economy, such as home loans.
When the FOMC chooses a new interest rate, it is really setting a target rate. The interest rate itself will ultimately be determined by the interaction of the money supply and the demand for money. But, the Fed will continue to use these open market operations until it achieves the interest rate that it has targeted.
Monetary policy influences aggregate demand, real output, the price level, and interest rates
Many central banks have a legal requirement to ensure price stability and full employment. This means that central banks use monetary policy to influence key variables like X and Y. We can summarize the impact monetary policy has on these variables as done in the table below:
| Monetary policy | effect on interest rates | effect on AD | effect on real output (Y) | effect on the price level (PL) | effect on unemployment |
|---|---|---|---|---|---|
| Expansionary monetary policy | n.i.r. ↓ | AD ↑ | Y ↑ | PL ↑ | UR ↓ |
| Contractionary monetary policy | n.i.r. ↑ | AD ↓ | Y ↓ | PL ↓ | UR ↑ |
The limitations of monetary policy
Monetary policy, like fiscal policy, suffers from lags that might hamper how effective it can be at closing an output gap. First of all, it takes time to recognize that there is a problem in the economy and react appropriately. Second, even if the interest rate changes quickly when OMOs are carried out, the impact of the interest rate change takes time.
Recall that OMOs impact the overnight rate. It takes time for changes in the overnight rate to pass through to other interest rates. Even once other interest rates have adjusted, the investment response to a new interest rate takes time
For example, suppose Inigo is thinking about buying a new home, but banks aren’t willing to lend any money right now because they are fully loaned out. Then, the central bank of Florin buys bonds, which increases the amount of funds available to loan out and decreases the interest rate banks charge each other.
Eventually, this changes the interest rate charged for home loans, too. Inigo sees that his local mortgage lender is offering lower interest rates. He takes out a loan and hires a builder to build his dream home. Only once he pays the builder will real GDP change.
Key Graphical Models
Figure 1 illustrates that when the central bank buys bonds, it increases the money supply. As a result of the increase in the money supply, the nominal interest rate will decrease.
Discussion questions
- The economy of Fredonia has experienced the demand shock shown here:
Part 1: Suppose the central bank wants to correct this gap. What is the appropriate open market operation? Explain.
Part 2: Show the impact of the OMO you chose on the money market
Part 3: Which curve in the AD-AS model would be impacted by this? How would it change? Explain.
Part 4: Would this cause the price level to increase, decrease, or stay the same? Explain.
Part 5: Would the unemployment rate increase, decrease, or stay the same? Explain.
The AD-AS model is illustrating an inflationary gap. Therefore contractionary monetary policy is appropriate. The O.M.O. to use in this circ*mstance is to sell bonds.
- The AD curve decreases. The increase in interest rates will decrease investment. The decrease in investment will decrease AD.
- This will cause the price level to decrease. When the AD curve decreases, the price level decreases
- The unemployment rate will increase. When the AD curve decreases, output will decrease. Fewer workers will be needed to produce less output, so the unemployment rate will increase.
