1. Section 3 Monetary Policy
The Fed’s Monetary Tools

2. Approaches to Monetary Policy
Policy 1: Expansionary Policy
Expansionary monetary policy also called easy- money policy
In recession, Fed increases money supply to increase aggregate demand
Fed can buy bonds on open market, decrease RRR or discount rate
most common practice is to buy bonds to make interest rates fall

3. Approaches to Monetary Policy
Policy 2: Contractionary Policy
Tight-money policy is another name for contractionary monetary policy
Fed decreases money supply to check aggregate demand, inflation
Fed can sell bonds on open market, increase RRR or discount rate
most common action is to sell bonds to raise interest rates

5. Impacts and Limitation of Monetary Policy
Purposes of monetary policy—curb inflation and halt recessions
Changes in monetary policy have both short-term and long- term effects

6. Impacts and Limitation of Monetary Policy
Impact 1: Short-Term Effects
The short-term effect is a change in the price of credit
Open market operations influence FFR fairly quickly
change loanable reserves banks have
Easy-money policy lowers interest rates; tight- money raises them

7. Impacts and Limitation of Monetary Policy
Impact 2: Policy Lags
Delays in getting information to identify problems delays Fed action
Policy adjustments may take a long time to take effect in the economy
example: businesses may delay expansion until interest rates drop

8. Impacts and Limitation of Monetary Policy
Impact 3: Timing Issues
Monetary policy must be coordinated with business cycle for stability
bad timing may exaggerate a phase of the business cycle
Monetarism holds that rapid changes in money supply cause instability
Milton Friedman found inflation goes with rapid growth in money supply
little or no inflation when money supply growth slow and steady

9. Impacts and Limitation of Monetary Policy
Other Issues
Monetary policy more effective if coordinated with fiscal policy
Goals of Fed may clash with those of Congress or President
governors serve 14 years; have less political pressure than politicians

10. Chapter 16 Section 4

11. Applying Monetary and Fiscal Policy
Fiscal and monetary policies impact each other
Both have limitations: policy lags, political constraints, timing issues
timing also affected by people’s actions based on rational expectations
Opponents of discretionary policy favor a stable monetary policy
thus people, businesses will not make decisions ahead of policies

12. Policies to Expand the Economy
Example: Expansionary Monetary and Fiscal Policy
Expansionary policy meant to reduce unemployment, increase investment
Expansionary fiscal policy raises interest rates; monetary lowers them
actual change in rates depends on relative strength of the two policies
amount of investment spending depends on rates

14. Policies to Control Inflation
Goal of contractionary monetary policy is to stabilize economy
decrease inflation and increase interest rates

15. Policies to Control Inflation
Example: Contractionary Monetary and Fiscal Policy
Contractionary policies decrease aggregate demand, control inflation
Fiscal policy lowers interest rates; monetary policy raises them
actual change in rates depends on relative strength of the two policies
amount of investment spending depends on rates

17. Policies to Control Inflation
Example: Wage and Price Controls
Government may establish non-mandatory wage and price guidelines
Wage and price controls—limits on increases in wages and prices
mandatory and enforced by government
WWII: President Roosevelt used to control inflation due to shortages
1970s: President Nixon used to try to combat stagflation

18. Policies in Conflict
Coordinated policies usually produce desired effect on economy
If uncoordinated, one policy can counter effects of the other
creates economic instability

19. Policies in Conflict Example: Conflicting Monetary and Fiscal Policies
Example: CPI is 6% and rising; unemployment is 7%
Fed tries to fix inflation by selling bonds, raising discount rate
government tries to lower unemployment by cutting taxes, more spending
Only clear result of conflicting policies is higher interest rates