How Do The Expansionary And Contractionary Monetary Policy Affect The Quantity Of Money

Budgetary Policy and Bank Regulation

Monetary Policy and Economic Outcomes

Learning Objectives

Past the end of this section, you will exist 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 lowers involvement rates and stimulates borrowing is an expansionary budgetary policy or loose monetary policy. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economic system is a contractionary budgetary policy or tight monetary policy. This module will discuss how expansionary and contractionary monetary policies affect involvement rates and amass demand, and how such policies volition bear on macroeconomic goals like unemployment and inflation. We will conclude with a wait at the Fed's monetary policy practise in recent decades.

The Effect of Budgetary Policy on Interest Rates

Consider the market place for loanable bank funds in (Figure). The original equilibrium (Due east₀) occurs at an viii% interest charge per unit and a quantity of funds loaned and borrowed of $ten billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S₀) to Southward₁, leading to an equilibrium (E₁) with a lower 6% interest rate and a quantity $14 billion in loaned funds. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply bend (Southward₀) to South_two, leading to an equilibrium (E₂) with a college 10% interest rate and a quantity of $8 billion in loaned funds.

Monetary Policy and Interest Rates

The original equilibrium occurs at E₀. An expansionary monetary policy will shift the supply of loanable funds to the correct from the original supply curve (S₀) to the new supply curve (Due south₁) and to a new equilibrium of E₁, reducing the interest rate from viii% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S₀) to the new supply (S_two), and raise the involvement rate from viii% to 10%.

How does a central bank "raise" interest rates? When describing the central banking concern'south monetary policy deportment, it is mutual to hear that the central bank "raised interest rates" or "lowered interest rates." Nosotros need to exist clear most this: more precisely, through open market place operations the cardinal bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, (Figure) shows that interest rates change. If they exercise not meet the Fed'south target, the Fed tin can supply more or less reserves until interest rates practice.

Recollect that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open up market place operations.

Of form, financial markets display a broad 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, likewise, and when the federal funds rate rises, other involvement rates ascension. Nonetheless, a fall or ascent of one percentage point in the federal funds charge per unit—which recall is for borrowing overnight—will typically take an effect of less than i percentage point on a xxx-twelvemonth loan to purchase a house or a 3-twelvemonth loan to purchase a car. Budgetary policy tin push the unabridged spectrum of interest rates higher or lower, merely the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.

The Issue of Monetary Policy on Aggregate Need

Monetary policy affects involvement rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary budgetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Concern investment will pass up because it is less attractive for firms to borrow money, and even firms that have money volition observe that, with higher involvement rates, it is relatively more attractive to put those funds in a financial investment than to brand an investment in concrete capital letter. In add-on, college involvement rates volition 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 volition tend to increase business investment and consumer borrowing for big-ticket items.

If the economy is suffering a recession and loftier unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. (Figure) (a) illustrates this situation. This example uses a short-run upwards-sloping Keynesian amass supply curve (SRAS). The original equilibrium during a recession of Eastward₀ occurs at an output level of 600. An expansionary budgetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate need curve (AD₀) to shift right to Advertising₁, so that the new equilibrium (East_one) occurs at the potential GDP level of 700.

Expansionary or Contractionary Budgetary Policy

(a) The economy is originally in a recession with the equilibrium output and toll shown at E₀. Expansionary monetary policy will reduce involvement rates and shift aggregate demand to the right from AD₀ to Ad₁, leading to the new equilibrium (E_ane) at the potential Gdp level of output with a relatively small rise in the price level. (b) The economic system is originally producing above the potential Gross domestic product level of output at the equilibrium E₀ and is experiencing pressures for an inflationary rise in the toll level. Contractionary budgetary policy will shift aggregate demand to the left from AD₀ to Ad₁, thus leading to a new equilibrium (E₁) at the potential Gdp level of output.

Conversely, if an economy is producing at a quantity of output in a higher place its potential Gross domestic product, a contractionary monetary policy tin can reduce the inflationary pressures for a rising price level. In (Figure) (b), the original equilibrium (East₀) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and crusade the original need bend (Advertising₀) to shift left to Advertising_ane, and then that the new equilibrium (E₁) occurs at the potential GDP level of 700.

These examples suggest that monetary policy should be countercyclical; that is, it should human activity to counterbalance the business cycles of economic downturns and upswings. The Fed should loosen budgetary policy when a recession has caused unemployment to increase and tighten it when inflation threatens. Of grade, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, information technology may push aggregate demand and so far to the right that it triggers aggrandizement. If tight monetary policy seeking to reduce inflation goes too far, it may button amass need and so far to the left that a recession begins. (Figure) (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level.

The Pathways of Monetary Policy

(a) In expansionary budgetary policy the fundamental depository financial institution causes the supply of money and loanable funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and shifting aggregate demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary budgetary 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 amass demand left. The result is a lower cost level and, at least in the short run, lower real GDP.

Federal Reserve Actions Over Final Four Decades

For the period from the mid-1970s upward through the end of 2007, we can summarize Federal Reserve monetary policy past looking at how it targeted the federal funds interest rate using open market operations.

Of course, telling the story of the U.S. economy since 1975 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 beneath as well demonstrate that nosotros should consider the central bank as 1 of the leading actors influencing the macro economic system. As we noted earlier, the single person with the greatest ability to influence the U.S. economy is probably the Federal Reserve chairperson.

(Figure) shows how the Federal Reserve has carried out monetary policy past targeting the federal funds involvement rate in the final few decades. The graph shows the federal funds interest rate (remember, this interest charge per unit is gear up through open market operations), the unemployment rate, and the inflation rate since 1975. Different episodes of monetary policy during this catamenia are indicated in the effigy.

Monetary Policy, Unemployment, and Inflation

Through the episodes here, the Federal Reserve typically reacted to higher inflation with a contractionary monetary policy and a higher interest rate, and reacted to higher unemployment with an expansionary monetary policy and a lower interest rate.

Episode one

Consider Episode 1 in the late 1970s. The charge per unit of inflation was very high, exceeding 10% in 1979 and 1980, so the Federal Reserve used tight monetary policy to heighten involvement rates, with the federal funds rate ascent from v.5% in 1977 to 16.iv% in 1981. By 1983, inflation was down to iii.two%, only amass need contracted sharply enough that back-to-back recessions occurred in 1980 and in 1981–1982, and the unemployment rate rose from 5.8% in 1979 to 9.7% in 1982.

Episode 2

In Episode 2, when economists persuaded the Federal Reserve in the early on 1980s that inflation was declining, the Fed began slashing involvement rates to reduce unemployment. The federal funds interest charge per unit fell from 16.4% in 1981 to vi.eight% in 1986. By 1986 or so, aggrandizement had fallen to nearly 2% and the unemployment rate had come down to seven%, and was still falling.

Episode iii

Still, in Episode iii in the late 1980s, inflation appeared to exist creeping up again, rising from 2% in 1986 up toward 5% past 1989. In response, the Federal Reserve used contractionary monetary policy to enhance the federal funds rates from 6.6% in 1987 to 9.2% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but information technology besides helped to cause the 1990-1991 recession, and the unemployment rate rose from 5.3% in 1989 to 7.5% by 1992.

Episode four

In Episode iv, in the early 1990s, when the Federal Reserve was confident that inflation was back nether control, it reduced interest rates, with the federal funds involvement rate falling from eight.one% in 1990 to 3.five% in 1992. As the economic system expanded, the unemployment charge per unit declined from 7.5% in 1992 to less than 5% by 1997.

Episodes 5 and vi

In Episodes 5 and 6, the Federal Reserve perceived a risk of aggrandizement and raised the federal funds rate from 3% to five.8% from 1993 to 1995. Aggrandizement did not ascent, and the period of economic growth during the 1990s connected. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest charge per unit from 4.6% in December 1998 to six.5% in June 2000. By early on 2001, inflation was declining once again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0% to five.8%.

Episodes seven and 8

In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2% in 2000 to just 1.7% in 2002, and so again to 1% in 2003. They actually did this because of fear of Japan-style deflation. This persuaded them to lower the Fed funds further than they otherwise would take. The recession concluded, just, unemployment rates were slow to decline in the early 2000s. Finally, in 2004, the unemployment rate declined and the Federal Reserve began to raise the federal funds charge per unit until it reached v% by 2007.

Episode 9

In Episode ix, as the Groovy Recession took hold in 2008, the Federal Reserve was quick to slash interest rates, taking them down to 2% in 2008 and to nearly 0% in 2009. When the Fed had taken involvement rates down to about-zero past Dec 2008, the economy was nevertheless deep in recession. Open marketplace operations could not make the interest rate turn negative. The Federal Reserve had to think "outside the box."

Quantitative Easing

The nigh powerful and commonly used of the three traditional tools of budgetary policy—open up market operations—works by expanding or contracting the money supply in a style that influences the involvement rate. In late 2008, as the U.Southward. economic system struggled with recession, the Federal Reserve had already reduced the interest rate to near-zip. 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 individual 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 central ways. Start, it involved the Fed purchasing long term Treasury bonds, rather than short term Treasury bills. In 2008, yet, it was incommunicable to stimulate the economy whatsoever further past lowering brusk term rates because they were already as depression every bit they could get. (Read the endmost Bring it Home characteristic for more on this.) Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing.

This leads to a 2d mode QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed "toxic assets," because when the housing market collapsed, no one knew what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. Past offer to purchase mortgage-backed securities, the Fed was both pushing long term interest rates down and also removing possibly "toxic assets" from the balance sheets of individual fiscal firms, which would strengthen the financial organisation.

Quantitative easing (QE) occurred in three episodes:

1. During QE_ane, which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.
2. In Nov 2010, the Fed began QE₂, in which it purchased $600 billion in U.Southward. Treasury bonds.
3. QE_three, began in September 2012 when the Fed commenced purchasing $forty billion of additional mortgage-backed securities per month. This amount was increased in December 2012 to $85 billion per month. The Fed stated that, when economic conditions allow, information technology will begin tapering (or reducing the monthly purchases). By Oct 2014, the Fed had appear the final $15 billion bond purchase, ending Quantitative Easing.

Nosotros usually retrieve of the quantitative easing policies that the Federal Reserve adopted (equally did other central banks around the earth) as temporary emergency measures. If these steps are to exist temporary, and so the Federal Reserve will need to stop making these boosted 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 QE_i was somewhat successful, merely that QE₂ and QE₃ take been less so.

Key Concepts and Summary

An expansionary (or loose) monetary policy raises the quantity of money and credit above what it otherwise would take been and reduces interest rates, boosting amass demand, and thus countering recession. A contractionary budgetary policy, besides chosen a tight budgetary policy, reduces the quantity of money and credit below what information technology otherwise would have been and raises interest rates, seeking to agree down inflation. During the 2008–2009 recession, central banks around the earth besides used quantitative easing to expand the supply of credit.

Cocky-Check Questions

Why does contractionary budgetary policy cause involvement rates to rise?

Contractionary policy reduces the amount of loanable funds in the economic system. Equally with all goods, greater scarcity leads a greater toll, and then the interest charge per unit, or the cost of borrowing money, rises.

Why does expansionary monetary policy causes interest rates to drop?

An increment in the corporeality of available loanable funds means that there are more people who desire to lend. They, therefore, bid the cost of borrowing (the interest rate) downwards.

Review Questions

How do the expansionary and contractionary budgetary policy impact the quantity of money?

How do tight and loose monetary policy touch on involvement rates?

How practice expansionary, tight, contractionary, and loose budgetary policy bear on aggregate demand?

Which kind of monetary policy would you expect in response to high inflation: expansionary or contractionary? Why?

Explain how to use quantitative easing to stimulate aggregate demand.

Disquisitional Thinking Question

A well-known economic model called the Phillips Curve (discussed in The Keynesian Perspective affiliate) describes the curt run tradeoff typically observed between inflation and unemployment. Based on the word of expansionary and contractionary monetary policy, explain why one of these variables usually falls when the other rises.

Glossary

contractionary monetary policy

a monetary policy that reduces the supply of money and loans

countercyclical

moving in the opposite direction of the concern cycle of economic downturns and upswings

expansionary monetary policy

a monetary policy that increases the supply of money and the quantity of loans

federal funds charge per unit

the interest charge per unit at which i bank lends funds to another bank overnight

loose monetary policy

meet expansionary budgetary policy

quantitative easing (QE)

the purchase of long term regime and private mortgage-backed securities by central banks to make credit bachelor in hopes of stimulating amass demand

tight monetary policy

meet contractionary budgetary policy

Source: https://opentextbc.ca/principlesofeconomics2eopenstax/chapter/monetary-policy-and-economic-outcomes/

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