Section 3 Monetary Policy The Feds Monetary Tools.
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Transcript of Section 3 Monetary Policy The Feds Monetary Tools.
Section 3 Monetary Policy
The Fed’s Monetary Tools
Approaches to Monetary PolicyPolicy 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
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 ratemost common action is to sell bonds to
raise interest rates
Alan Greenspan: Fighting Inflation
Managing Monetary PolicyGreenspan served as chair of Fed’s Board of Governors over 18 yearshis insight and
persuasiveness made him extremely influential
Alan Greenspan: Fighting Inflation
Was very successful at growing economy without inflationgreat knowledge of
tools of monetary policy and economic indicators
sense of timing: knew just when to expand or contract money supply
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
Impacts and Limitation of Monetary PolicyImpact 1: Short-Term Effects
The short-term effect is a change in the price of credit
Open market operations influence FFR fairly quicklychange loanable reserves banks have
Easy-money policy lowers interest rates; tight-money raises them
Impacts and Limitation of Monetary PolicyImpact 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 economyexample: businesses may delay
expansion until interest rates drop
Impacts and Limitation of Monetary Policy
Impact 3: Timing IssuesMonetary policy must be coordinated with business cycle for stabilitybad 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 supplylittle or no inflation when money supply growth
slow and steady
Impacts and Limitation of Monetary PolicyOther Issues
Monetary policy more effective if coordinated with fiscal policy
Goals of Fed may clash with those of Congress or Presidentgovernors serve 14 years; have less
political pressure than politicians
QuestionsWhich 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%
Chapter 16 Section 4
Fiscal and monetary policies impact each other
Both have limitations: policy lags, political constraints, timing issuestiming also affected by people’s
actions based on rational expectations Opponents of discretionary policy favor
a stable monetary policythus people, businesses will not make
decisions ahead of policies
Applying Monetary and Fiscal Policy
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 themactual change in rates depends on
relative strength of the two policiesamount of investment spending depends
on rates
Policies to Control InflationGoal of contractionary monetary
policy is to stabilize economydecrease inflation and increase
interest rates
Policies to Control InflationExample: Contractionary Monetary
and Fiscal PolicyContractionary policies decrease aggregate demand, control inflation
Fiscal policy lowers interest rates; monetary policy raises themactual change in rates depends on
relative strength of the two policiesamount of investment spending
depends on rates
Policies to Control Inflation
Example: Wage and Price ControlsGovernment may establish non-
mandatory wage and price guidelines Wage and price controls—limits on
increases in wages and pricesmandatory and enforced by governmentWWII: President Roosevelt used to control
inflation due to shortages1970s: President Nixon used to try to
combat stagflation
Policies in ConflictCoordinated policies usually
produce desired effect on economyIf uncoordinated, one policy can
counter effects of the othercreates economic instability
Policies in Conflict
Example: Conflicting Monetary and Fiscal PoliciesExample: CPI is 6% and rising; unemployment is 7%Fed tries to fix inflation by selling bonds,
raising discount rategovernment tries to lower unemployment
by cutting taxes, more spendingOnly clear result of conflicting policies is higher interest rates
Interpreting Signals from the FedBackground
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 IssueHow 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?
QuestionsWhat 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 -