Monetary Policy

• Monetary policy


  A policy which employs the central bank's control of the supply of money as an instrument for achieving the objectives of the general economic policy
• Monetary policy


  • CB influences the total amount and the cost of credit primarily by affecting the cash reserves of commercial banks in the economy
  • To maximum employment, stable prices, and moderate long-term interest rates

  
• Objectives of monetary policy

  • Maintain domestic price stability
  • Achieve full employment
  • Achieve a higher rate of economic growth
  • Maintain a continuously low structure of interest rate
  • Maintain BOP equilibrium
• Goals of monetary policy

  Maximum employment, stable prices, and moderate long-term interest rates
• In the long run, these goals are in harmony and reinforce each other, but in the short run, they might be in conflict
• Key goal of monetary policy

  Price stability
• Price stability is the source of maximum employment and moderate long-term interest rates
• Means for achieving monetary policy goals

  By keeping the growth rate of the quantity of money in line with the growth rate of potential GDP, the Fed is expected to be able to maintain full employment and keep the price level stable

  
• Output gap


  The percentage deviation of real GDP from potential GDP
• A positive output gap


  Indicates an increase in inflation
• A negative output gap


  Indicates unemployment above the natural rate
• The Fed tries to minimize the output gap
• Federal funds rate


  The short term interest rate
• The Fed's choice of policy instrument is the federal funds rate
• The Fed sets a target for the federal funds rate and then takes actions to keep it close to its target
• Open market operations


  1. Purchase or sale of government securities by the Fed from or to a commercial bank or the public

  2. During inflation, the Fed will reduce the cash reserves of commercial banks by selling securities

  3. During unemployment, the Fed will purchase securities and increase the cash reserves of commercial banks, and thus increase the money supply in the economy

  
• The Fed's decision-making strategy

  1. Intensive assessment of the current state of the economy

  2. Forecast inflation rate

  3. Forecast unemployment rate

  4. Forecast output gap
• Expansionary monetary policy


  Policy aimed at increasing the money supply in the economy
• Contractionary monetary policy


  Policy adopted to decrease the money supply in the economy

  
• Monetary policy transmission - fighting recession

  1. If inflation is low and the output gap is negative, the FOMC lowers the federal funds rate target

  2. Increase in the monetary base increases the supply of money

  3. Short-term interest rate falls

  4. Increase in the supply of money increases the supply of loanable funds

  5. Real interest rate falls

  6. Fall in the real interest rate increases aggregate planned expenditure

  7. Real GDP increases to potential GDP

  
• Monetary policy transmission - fighting inflation

  1. If inflation is too high and the output gap is positive, the FOMC raises the federal funds rate target

  2. Decrease in the monetary base decreases the supply of money

  3. Short-term interest rate rises

  4. Decrease in the supply of money decreases the supply of loanable funds

  5. Real interest rate rises

  6. Increase in real interest rate decreases aggregate planned expenditure

  7. Real GDP decreases and closes the inflationary gap

  
• Legal cash reserve requirement

  The minimum amount of cash that the central bank requires all commercial banks to keep in the central bank
• Decreasing the minimum legal cash reserve ratio


  Results in excess cash reserves and this becomes available for credit creation by the banks

  
• During inflation, the central bank will raise the minimum legal cash reserve ratio


  In order to restrain credit creation by commercial banks and thus reduce the money supply
• Discount rate or bank rate

  The interest rate the central bank charges on loans of reserves to banks
• If the central bank increases its bank rate

  The interest rate on borrowing becomes more expensive and this will lead to a decrease in the demand for loans
• Increase in bank rates

  A tool in contractionary monetary policy and usually occurs during inflation
• Limitations of monetary policy include administrative lag
• It takes a while for the central bank to recognize whether the economy is receding or the rate of inflation is rising due to the monthly variations of economic activity and changes in the price level
• Once the central bank acts, it may take three to six months for interest-rate changes to have their full impacts on investment, aggregate demand, aggregate output, and the price level