Monetary Policy A Powerful Tool for Economic Stabilization

Definitions  Expansionary: Increase in the growth rate of H and therefore of the money supply  Contractionary: The reverse

Why Expansion?  Monetary expansion => increase in supply of money => lower value of money in the form of lower interest rates and exchange rate depreciation  Businesses & consumers borrow more & spend more  Exports rise, imports fall

Why Contraction?  Monetary contraction does the opposite: interest rates up, the exchange value of the currency rises  Spending falls, but that will slow inflationary tendencies even at the cost of jobs

A Tale of Two Interest Rates  The discount rate: the rate at which the central bank lends reserves directly to commercial banks  The federal funds rate: the rate at which commercial banks lend reserves to each other  These rates, particularly the FF rate, are the ones Greenspan raises or lowers when monetary policy changes

Open Market Operations  News: Greenspan raised rates (Last week). What does that mean?  G’span sold securities to commercial banks (OMO); they paid by giving up reserves to the FED (US central bank)

Scarce Reserves  Reserves are now scarcer; anything scarcer is more valuable  The federal funds rate is a market rate; scarcity of reserves, the thing traded, induces higher prices (ff rate)  That’s all he did!

Reserves  The scarcity of reserves, that R in the equations and accounts, may be only relative (slower growth rate), but remains a powerful mover  The entire money supply will grow more slowly

Why is this Important?  M, the money stock, is a store of potential purchasing power  It also has power as potential savings  It is always sitting somewhere, in someone’s pocket or bank account, just waiting to be used