Monetary PolicyMonetary Policy

A Powerful Tool for A Powerful Tool for Economic StabilizationEconomic Stabilization

DefinitionsDefinitions

Expansionary: Increase in the Expansionary: Increase in the growth rate of H and therefore growth rate of H and therefore of the money supplyof the money supply

Contractionary: The reverseContractionary: The reverse

Why Expansion?Why Expansion?

Monetary expansion => increase Monetary expansion => increase in in supply supply of money => lower of money => lower valuevalue of money in the form of lower of money in the form of lower interest rates and exchange rate interest rates and exchange rate depreciationdepreciation

Businesses & consumers borrow Businesses & consumers borrow more & spend moremore & spend more

Exports rise, imports fallExports rise, imports fall

Why Contraction?Why Contraction?

Monetary contraction does the Monetary contraction does the opposite: interest rates up, the opposite: interest rates up, the exchange value of the currency exchange value of the currency risesrises

Spending falls, but that will Spending falls, but that will slow inflationary tendencies slow inflationary tendencies even at the cost of jobseven at the cost of jobs

A Tale of Two Interest RatesA Tale of Two Interest Rates

The discount rate: the rate at which The discount rate: the rate at which the central bank lends reserves the central bank lends reserves directly to commercial banksdirectly to commercial banks

The federal funds rate: the rate at The federal funds rate: the rate at which commercial banks lend which commercial banks lend reserves to each otherreserves to each other

These rates, particularly the FF rate, These rates, particularly the FF rate, are the ones Greenspan raises or are the ones Greenspan raises or lowers when monetary policy changeslowers when monetary policy changes

Open Market OperationsOpen Market Operations

News: Greenspan raised rates News: Greenspan raised rates (Last week). What does that (Last week). What does that mean?mean?

G’span sold securities to G’span sold securities to commercial banks (OMO); they commercial banks (OMO); they paid by giving up reserves to the paid by giving up reserves to the FED (US central bank)FED (US central bank)

Scarce ReservesScarce Reserves

Reserves are now scarcer; Reserves are now scarcer; anything scarcer is more valuableanything scarcer is more valuable

The federal funds rate is a market The federal funds rate is a market rate; scarcity of reserves, the rate; scarcity of reserves, the thing traded, induces higher thing traded, induces higher prices (ff rate) prices (ff rate)

That’s all he did! That’s all he did!

ReservesReserves

The scarcity of reserves, that The scarcity of reserves, that RR in the equations and in the equations and accounts, may be only relative accounts, may be only relative (slower growth rate), but (slower growth rate), but remains a powerful mover remains a powerful mover

The entire money supply will The entire money supply will grow more slowlygrow more slowly

Why is this Important?Why is this Important?

M, the money stock, is a store of M, the money stock, is a store of potential purchasing powerpotential purchasing power

It also has power as potential It also has power as potential savingssavings

It is always sitting somewhere, in It is always sitting somewhere, in someone’s pocket or bank someone’s pocket or bank account, just waiting to be usedaccount, just waiting to be used