Federal Reserve Chapter 16 Section 4 Monetary Policy and Macroeconomic Stabilization

Federal Reserve  Objectives:  1. Understand how monetary policy works.  2. Explain the problems of timing and policy lags in implementing monetary policy.  3. Explain how predictions about the length of a business cycle affect monetary policy.  4. Describe two distinct approaches to monetary policy.

Federal Reserve  Monetarism – the belief that the money supply is the most important factor in macroeconomic performance.

Federal Reserve  How Monetary Policy Works: Monetary policy alters the supply of money. The supply of money, in turn, affects interest rates. Interest rates affect the level of investment and spending in the economy.

Federal Reserve  The Money Supply and Interest Rates: It is easy to see the cost of money if you are borrowing it. The cost – the price that you as borrower pay – is the interest rate. Even if you have your own money, the interest rate still affects you. The interest rate is also the cost of having money because you are giving up interest by not saving or investing. Interest rate is always the cost of money.

Federal Reserve  The market for money is like any other market.  If the supply is higher, the price – the interest rate – is lower.  If the supply is lower, the price – the interest rate – is higher.  In other words, when the money supply is low, the interest rates are high.  When the money supply is high, the interest rates are low.

Federal Reserve  Lower interest rates encourage greater investment spending by business firms.  This is because the firm’s cost of borrowing decreases.  It also gives firms more opportunities for profit.  If the interest rates are very high, the chance for profit are very low.  Likewise if interest rates are low, the chance for profit are very high.

Federal Reserve  If the macro-economy is experiencing a contraction- declining income – the Fed may want to stimulate or expand the it.  Easy Money Policy – The Fed will increase the money supply – lower interest rates that encourage borrowing and investment.  Tight Money Policy – The Fed will decrease money supply – higher interest rates that cause investment spending to decline.

Federal Reserve  The Problem of Timing: Monetary policy must be carefully timed if it is to help the macro-economy. If policies are enacted at the wrong time, they could actually intensify the business cycle, rather than smooth it out.

Federal Reserve  Good Timing: The goal of stabilization policy is to smooth out those fluctuations – in other words – to make the peaks a little bit lower and the troughs not quite as deep. This will minimize inflation in the peaks and the effects of recessions in the trough.

Federal Reserve  Bad Timing: If stabilization policy is not timed properly, it can actually make the business cycle worse, not better. It takes time to enact expansionary policies and have those policies take effect. By the time all of this takes place, the economy may already be coming out of the recession on its own.

Federal Reserve  Policy Lags: Inside Lags: are delays in implementing policy.  Two reasons for the lag 1. it takes to time to identify and recognize a problem.  Even with computer program models – they cannot for sure predict exactly what will happen. 2. once a problem has been recognized, it can take additional time to enact appropriate policy.

Federal Reserve -Outside Lags: is the time period it takes for a new policy to become effective. -Fiscal Policy – government has to recognize the problem and then implement new ideas. -Monetary policy is much quicker.

Federal Reserve  Predicting the Business Cycle The Fed must not only react to current trends, but also it must anticipate changes in the economy. Monetary Policy and Inflation  An inflationary economy can be tamed with a tight monetary policy.  The timing has to be just right.  If the policy takes effect as the economy is cooling off on its own, the tight money could turn a mild contraction into a full- blown recession.

Federal Reserve  To use monetary policy depends on the expectations of the business cycle.  Some recessions are short run and others end up being long run.  The biggest problem with any enactment of a policy change is that of the timing. The hardest part is getting the timing right.

Federal Reserve  How long does an economy self-correct itself? Estimates range from 2-6 years. Policy-makers have some time to make changes to try and correct the recessions in the economy.

Federal Reserve  Fiscal & Monetary Policy: Expansionary Tools  Fiscal Policy – Increase government spending or -Cut taxes  Monetary Policy Open market operations: bond purchases Decrease the discount rate Decrease reserve requirements

Federal Reserve  Fiscal & Monetary Policy: Contractionary Tools  Fiscal Policy Decrease government spending Raising Taxes  Monetary Policy Open market operations: sell bonds Increase the discount rate Increase reserve requirements