4.6 Monetary Policy
Central banks steer output and inflation by moving interest rates: expansionary policy lowers rates to boost AD; contractionary policy raises them.
In a limited-reserves framework, the Fed's tools are open market operations, the reserve requirement, and the discount rate. Buying bonds injects reserves, shifts the money supply right, and lowers the nominal interest rate; selling bonds does the reverse. OMOs are the classic tool tested most.
In today's ample-reserves framework (now in the CED), banks hold so many reserves that small changes in their quantity no longer move rates. Instead the Fed sets administered rates — chiefly interest on reserve balances (IORB), plus the discount rate — to steer the federal funds rate. Raising IORB raises market rates; lowering it eases policy.
Either way, the transmission chain is the same: a lower interest rate stimulates investment and interest-sensitive consumption, shifting AD right and raising output and the price level. Contractionary policy raises rates and shifts AD left to fight inflation. FRQs want each link stated in order — rate, then spending, then AD, then output and price level.
Key terms for 4.6
Drag the curves yourself — the fastest way to make 4.6 stick.
Practice the math
Reversing open market operations. The Fed BUYS bonds to expand the money supply and lower interest rates, and SELLS bonds to contract it — 'buy big, sell small.'
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