Monetary Policy
What is Monetary Policy?
Monetary policy is the central bank's use of the money supply and interest rates to influence the economy.
The central bank (the Federal Reserve in the U.S.) uses open market operations, the discount rate, and reserve requirements to change the money supply. Expansionary (easy) policy lowers interest rates to boost borrowing and aggregate demand; contractionary (tight) policy raises rates to fight inflation. Unlike fiscal policy, it is controlled by the central bank.
Monetary Policy: a worked example
Suppose the money market clears at a nominal interest rate of 5 percent while the economy sits in a recessionary gap. The Federal Reserve buys government bonds on the open market, which adds reserves to the banking system and shifts the vertical money supply curve right, so in this example the equilibrium rate falls from 5 percent to 3 percent. Cheaper borrowing raises interest sensitive investment and purchases of consumer durables, shifting aggregate demand right and moving real GDP back toward potential. The Federal Reserve used expansionary policy on a large scale in December 2008, when the FOMC cut its federal funds target to a range of 0 to 0.25 percent.
The mistake students make with monetary policy
Students say the Federal Reserve simply picks the interest rate, then draw a money market graph with the rate moved down and no curve shifted. In the money market model the rate is an equilibrium outcome: an open market purchase of bonds shifts the vertical money supply curve right, and the nominal interest rate falls as borrowers and lenders move along an unchanged money demand curve. A correct expansionary diagram shows money supply shifting right with money demand held fixed.
Monetary Policy questions
What is the difference between monetary policy and fiscal policy?
Monetary policy is the central bank's use of the money supply and interest rates to influence the economy, while fiscal policy is the government's use of spending and taxation, so in the United States the Federal Reserve runs monetary policy and Congress and the President run fiscal policy. Both shift aggregate demand, but monetary policy acts indirectly by changing interest rates and therefore investment.
What are the three tools of monetary policy?
The three traditional tools of monetary policy are open market operations, meaning the buying and selling of government bonds, the discount rate charged to banks that borrow from the central bank, and the reserve requirement. Open market operations are the tool the Federal Reserve uses most often.
Does expansionary monetary policy cause inflation?
Expansionary monetary policy can cause inflation, because a larger money supply lowers interest rates and raises aggregate demand, which pushes the price level up. The inflation risk is small when the economy is producing well below full employment and large when output is already at or above potential.
Formula / Example
This is the live Money Market sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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