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
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
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).