Monetary Policy and the Fed

Read this chapter to understand in more detail the monetary policy tools, process, and impacts on the U.S. economy. Review specific monetary policies and their effects from our recent history.

Monetary Policy in the United States

Monetary Policy and Macroeconomic Variables

We saw in an earlier chapter that the Fed has three tools at its command to try to change aggregate demand and thus to influence the level of economic activity. It can buy or sell federal government bonds through open-market operations, it can change the discount rate, or it can change reserve requirements. It can also use these tools in combination. In the next section of this chapter, where we discuss the notion of a liquidity trap, we will also introduce more extraordinary measures that the Fed has at its disposal.

Most economists agree that these tools of monetary policy affect the economy, but they sometimes disagree on the precise mechanisms through which this occurs, on the strength of those mechanisms, and on the ways in which monetary policy should be used. Before we address some of these issues, we shall review the ways in which monetary policy affects the economy in the context of the model of aggregate demand and aggregate supply. Our focus will be on open-market operations, the purchase or sale by the Fed of federal bonds.


Expansionary Monetary Policy

The Fed might pursue an expansionary monetary policy in response to the initial situation shown in Panel (a) of Figure 11.1 "Expansionary Monetary Policy to Close a Recessionary Gap". An economy with a potential output of YP is operating at Y1; there is a recessionary gap. One possible policy response is to allow the economy to correct this gap on its own, waiting for reductions in nominal wages and other prices to shift the short-run aggregate supply curve SRAS1 to the right until it intersects the aggregate demand curve AD1 at YP. An alternative is a stabilization policy that seeks to increase aggregate demand to AD2 to close the gap. An expansionary monetary policy is one way to achieve such a shift.

To carry out an expansionary monetary policy, the Fed will buy bonds, thereby increasing the money supply. That shifts the demand curve for bonds to D2, as illustrated in Panel (b). Bond prices rise to Pb2. The higher price for bonds reduces the interest rate. These changes in the bond market are consistent with the changes in the money market, shown in Panel (c), in which the greater money supply leads to a fall in the interest rate to r2. The lower interest rate stimulates investment. In addition, the lower interest rate reduces the demand for and increases the supply of dollars in the currency market, reducing the exchange rate to E2 in Panel (d). The lower exchange rate will stimulate net exports. The combined impact of greater investment and net exports will shift the aggregate demand curve to the right. The curve shifts by an amount equal to the multiplier times the sum of the initial changes in investment and net exports. In Panel (a), this is shown as a shift to AD2, and the recessionary gap is closed.

Figure 11.1 Expansionary Monetary Policy to Close a Recessionary Gap

figure 11.1


In Panel (a), the economy has a recessionary gap YP − Y1. An expansionary monetary policy could seek to close this gap by shifting the aggregate demand curve to AD2. In Panel (b), the Fed buys bonds, shifting the demand curve for bonds to D2 and increasing the price of bonds to Pb2. By buying bonds, the Fed increases the money supply to M′ in Panel (c). The Fed's action lowers interest rates to r2. The lower interest rate also reduces the demand for and increases the supply of dollars, reducing the exchange rate to E2 in Panel (d). The resulting increases in investment and net exports shift the aggregate demand curve in Panel (a).
Contractionary Monetary Policy

The Fed will generally pursue a contractionary monetary policy when it considers inflation a threat. Suppose, for example, that the economy faces an inflationary gap; the aggregate demand and short-run aggregate supply curves intersect to the right of the long-run aggregate supply curve, as shown in Panel (a) of Figure 11.2 "A Contractionary Monetary Policy to Close an Inflationary Gap".

Figure 11.2 A Contractionary Monetary Policy to Close an Inflationary Gap

figure 11.2


In Panel (a), the economy has an inflationary gap Y1 − YP. A contractionary monetary policy could seek to close this gap by shifting the aggregate demand curve to AD2. In Panel (b), the Fed sells bonds, shifting the supply curve for bonds to S2 and lowering the price of bonds to Pb2. The lower price of bonds means a higher interest rate, r2, as shown in Panel (c). The higher interest rate also increases the demand for and decreases the supply of dollars, raising the exchange rate to E2 in Panel (d), which will increase net exports. The decreases in investment and net exports are responsible for decreasing aggregate demand in Panel (a).

To carry out a contractionary policy, the Fed sells bonds. In the bond market, shown in Panel (b) of Figure 11.2 "A Contractionary Monetary Policy to Close an Inflationary Gap", the supply curve shifts to the right, lowering the price of bonds and increasing the interest rate. In the money market, shown in Panel (c), the Fed's bond sales reduce the money supply and raise the interest rate. The higher interest rate reduces investment. The higher interest rate also induces a greater demand for dollars as foreigners seek to take advantage of higher interest rates in the United States. The supply of dollars falls; people in the United States are less likely to purchase foreign interest-earning assets now that U.S. assets are paying a higher rate. These changes boost the exchange rate, as shown in Panel (d), which reduces exports and increases imports and thus causes net exports to fall. The contractionary monetary policy thus shifts aggregate demand to the left, by an amount equal to the multiplier times the combined initial changes in investment and net exports, as shown in Panel (a).