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Once you have completed this assignment, please save it in. docx or RTF format and upload it through the Unit 7 Problem Assignment folder. A monetary policy that lowers interest rates and stimulates borrowing is an expansionary monetary policy or loose monetary policy. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy or tight monetary policy.
This module will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation.
Consider the market for loanable bank funds in Figure Figure As a result, Figure Recall that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, sinceestablished its target federal funds rate in advance of any open market operations.
Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time.
In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise.
However, a fall or rise of one percentage point in the federal funds rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, homework helpster grade 2, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.
Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital.
In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars.
Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items.
If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP.
This example uses a short-run upward-sloping Keynesian aggregate supply curve SRAS. The original equilibrium during a recession of E0 occurs at an output level of An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve AD0 to shift right to AD1, so that the new equilibrium E1 occurs at the potential GDP level of Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium E1 at the potential GDP level of output with a relatively small rise in the price level.
b The economy is originally producing above the potential GDP level of output at the equilibrium E0 and is experiencing pressures for an inflationary rise in the price level. Contractionary monetary policy will shift aggregate demand to the left from AD0 to AD1, homework helpster grade 2 leading to a new equilibrium E1 at the potential GDP level of output, homework helpster grade 2.
Conversely, if an economy is producing at a quantity homework helpster grade 2 output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a homework helpster grade 2 price level.
In Figure A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause homework helpster grade 2 original demand curve AD0 to shift left to AD1, so that the new equilibrium E1 occurs at the potential GDP level of These examples suggest that monetary policy should be countercyclical ; that is, it should act to counterbalance the business cycles of economic downturns and upswings.
The Fed should loosen monetary policy when a recession has caused unemployment to increase and tighten it when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins.
The result is a higher price level and, at least in the short run, homework helpster grade 2, higher real GDP. b In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left.
The result is a lower price level and, at least in the short run, lower real GDP. For the period from the mids up through the end ofwe can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations. Of course, telling the story of the U. economy since in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and inflation over this time.
The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U. economy is probably the Federal Reserve chairperson. The graph shows the federal funds interest rate remember, this interest rate is set through open market operationsthe unemployment rate, and the inflation rate since Different episodes of monetary policy during this period are indicated in the figure.
Consider Episode 1 in the late s. Byhomework helpster grade 2, inflation was down to 3. In Episode 2, when economists persuaded the Federal Reserve in the early s that inflation was declining, homework helpster grade 2, the Fed began slashing interest rates to reduce unemployment.
The federal funds interest rate fell from In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6. In Episode 4, in the early s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8. As the economy expanded, the unemployment rate declined from 7.
Inflation did not rise, and the period of economic growth during the s continued. Then in andthe Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4, homework helpster grade 2. By earlyinflation was declining again, but a recession occurred in Between andthe unemployment rate rose from 4. In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal homework helpster grade 2 rate from 6.
They actually did this because of fear of Japan-style deflation. This persuaded them to lower the Fed funds further than they otherwise would have. The recession ended, homework helpster grade 2, but, unemployment rates were slow to decline in the early s.
When the Fed had taken interest rates down to near-zero by Decemberthe economy was still deep in recession. Open market operations could not make the interest rate turn negative. The most powerful and commonly used of the three traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate.
In lateas the U. economy struggled with recession, the Federal Reserve had already reduced the interest rate to near- zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing QE. This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand.
Quantitative easing differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long term Treasury bonds, rather than short term Treasury bills. Inhowever, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get. Read the closing Bring it Home homework helpster grade 2 for more on this.
Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing. This leads to a second way QE is different homework helpster grade 2 traditional monetary policy. Instead of purchasing Treasury securities, the Fed also homework helpster grade 2 purchasing private mortgage-backed securities, something it had never done before. We usually think of the quantitative easing policies that the Federal Reserve adopted as did other central banks around the world as temporary emergency measures.
If these steps are to be temporary, homework helpster grade 2, then the Federal Reserve will need to stop making these additional loans and sell off the financial securities it has accumulated. The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact. The evidence suggests that QE1 was somewhat successful, but that QE2 and QE3 have been less so. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution 4.
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Draw a graph depicting interest rates at the quantity of loanable funds such as the graph in figure Answer the following questions regarding this graph. Explain why the demand of loanable funds is upward sloping. Explain why the supply of loanable funds is downward sloping. If the Federal Reserve sells government bonds, show what will happen to this graph. Explain the effects on interest rates and the quantity of loanable funds.
If the Federal Reserve lowers the required reserve rate, show what will happen to this graph. Do cigarettes in prison have the ability to satisfy these four functions? Homework helpster grade 2, provide a brief explanation to justify your answer. If the velocity of money increases and nothing else changes, nominal GDP will rise.
If the value of M1 increases and nothing else changes, the value of M2 will also increase. Monetary Policy and Economic Outcomes By the end of this section, you will be able to: Contrast expansionary monetary policy and contractionary monetary policy Explain how monetary policy impacts interest rates and aggregate demand Evaluate Federal Reserve decisions over the last forty years Explain the significance of quantitative easing QE A monetary policy that homework helpster grade 2 interest rates and stimulates borrowing is an expansionary monetary policy or loose monetary policy.
The Effect of Monetary Policy on Interest Rates Consider the market for homework helpster grade 2 bank funds in Figure The Effect of Monetary Policy on Aggregate Demand Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Federal Reserve Homework helpster grade 2 Over Last Four Decades For the period from the mids up through the end ofwe can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations.
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