Monetary Policy:
Actions the Federal Reserve takes to control the money
supply and interest rates in pursuit of macroeconomic policies.
There are four primary policy goals for monetary policy:
- Price stability (inflation control)
- High employment (or low unemployment)
- Stability of financial markets and institutions (through regulation and transparency)
- Economic Growth (promoting sound investments)
The Federal Reserve tries to keep both unemployment and
inflation low, but it cannot affect these
variables directly. It uses the money supply to indirectly affect
unemployment and inflation. There is
also usually a tradeoff between unemployment and inflation when changing the
money supply. For example, during an
expansion of the money supply, there is more money in the economy so more goods
can be purchased and unemployment tends to fall. However, with more money in the economy
inflation tends to rise. Likewise, by
contracting the money supply, unemployment tends to rise and inflation tends to
fall, so the Federal Reserve has to put a lot of thought into their actions in
the economy.
We can better understand these relationships by considering
the demand for money within an economy.
You can see that the money demand (MD) line is downward sloping,
which means that a decrease in the interest rates will lead to an increased
amount of money that is demanded.
Likewise, an increase in the interest rates will lead to a lower amount
of money that is demanded. The intuition
behind this can be found in your own personal saving strategy. The amount of money you keep in your wallet
or your checking account (which earns little to no interest) is a lot less than
the amount of money you keep in a savings account, CD’s, bonds or stocks. When the return to these accounts are high
(high interest rates), you are less likely to keep money lying around. However, when these accounts earn little
interest (0 to 1% like now) then there is no real opportunity cost to keeping
all of your money in your wallet or checking account, so the quantity of money
that you demand (hold in your wallet or checking account) is high.
The two most common circumstances that will cause the demand
for money line to shift are changes in GDP and the price level. Note that changes in the interest rate are
already accounted for in the model (because they are on the Y axis).
An increase in GDP means that there are more goods and
services in the economy that can be purchased.
This will cause the MD line to shift right or increase because people
need more money to function in this economy with more stuff. Also, if the price level rises, then
everything else equal, people will need more money to function in this economy
with higher prices and we will see the MD line shift right or increase.
On the opposite side, a reduction in GDP means that there
are less goods and services in the economy so less money is needed. This will cause the MD line to shift left, or
decrease the amount of money that is demanded in the economy. Also, if price levels fall, people will need
less money to complete their necessary transactions so we will see the MD line
shift left or decrease.
How the Federal Reserve can control the money supply:
The Federal Reserve controls the money supply buy purchasing
and selling U.S. treasury securities.
When the Federal Open Market Committee (FOMC) decides to increase the
money supply, they do so by buying these treasury securities from banks. They give the banks money in exchange for the
securities. This increases the amount of
money that banks have, which increases their money reserves which they can then
lend out to people who want to borrow money.
Likewise, when the FOMC sells U.S. treasury securities, they
receive money from the banks. This means
that banks have less money to loan out to those who want to borrow, which
lowers the supply of money available in the economy.
You can see in the graph above that an increase in the money
supply shifts the MS curve to the right to MSi.
This results in a reduction of the interest rate because of the downward
sloping nature of the demand curve.
Likewise, if the Federal Reserve decides to decrease the money supply,
we will see interest rates rise, because of the upward sloping nature of the
money demand curve.
You may remember that we have two models that help us
determine what the interest rate will be in an economy. What happens, for example, if the interest
rate in the loanable funds market decreases, but we see no change in this
demand and supply for money model? The
truth is that the money model determines short term interest rates, and the
loanable funds market determines long term interest rates. It is generally true that fluctuations in the
short term interest rate will have longer term effects that then show up in the
loanable funds market.
The Federal funds rate is the interest rate that banks
charge each other for overnight loans.
This is important because banks have to keep 10 percent of their
checking account deposits as either currency on hand, or through deposits with
the Federal Reserve. In order to make
sure they meet this requirement every day, they sometimes have to borrow money
in the very short term (daily). The Federal
Reserve does not directly set the Federal Funds rate, but can influence it
indirectly by supplying more or less money through their open market
operations.
