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

Monetary Policy and Bank Regulation

Monetary Policy and Economical Outcomes

Learning Objectives

Past the end of this department, you lot volition be able to:

• Dissimilarity expansionary budgetary policy and contractionary monetary policy
• Explain how budgetary policy impacts interest rates and aggregate need
• Evaluate Federal Reserve decisions over the terminal 40 years
• Explain the significance of quantitative easing (QE)

A monetary policy that lowers involvement rates and stimulates borrowing is an expansionary monetary policy or loose budgetary 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 budgetary policies touch on interest rates and amass need, and how such policies will touch on macroeconomic goals like unemployment and inflation. We will conclude with a look at the Fed's monetary policy practice in recent decades.

The Issue of Monetary Policy on Involvement Rates

Consider the market place for loanable depository financial institution funds in (Effigy). The original equilibrium (E₀) occurs at an viii% involvement rate and a quantity of funds loaned and borrowed of $ten billion. An expansionary budgetary policy volition shift the supply of loanable funds to the right from the original supply curve (S₀) to S_i, leading to an equilibrium (E₁) with a lower 6% interest rate and a quantity $14 billion in loaned funds. Conversely, a contractionary monetary policy volition shift the supply of loanable funds to the left from the original supply curve (S₀) to South₂, leading to an equilibrium (Due east₂) with a higher 10% interest rate and a quantity of $eight 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 bend (S₀) to the new supply curve (S₁) and to a new equilibrium of E₁, reducing the involvement rate from viii% to six%. A contractionary monetary policy volition shift the supply of loanable funds to the left from the original supply curve (S₀) to the new supply (South₂), and enhance the interest charge per unit from 8% to ten%.

How does a central banking company "enhance" involvement rates? When describing the primal banking concern's monetary policy actions, it is common to hear that the central bank "raised interest rates" or "lowered interest rates." Nosotros demand to be articulate about this: more precisely, through open market place operations the key bank changes bank reserves in a way which affects the supply bend of loanable funds. Every bit a upshot, (Figure) shows that interest rates modify. If they practise non encounter the Fed's target, the Fed can supply more than or less reserves until interest rates practise.

Recall that the specific interest rate the Fed targets is the federal funds charge per unit. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open marketplace operations.

Of form, fiscal markets brandish a wide range of interest rates, representing borrowers with dissimilar hazard premiums and loans that they must repay over different periods of time. In full general, when the federal funds rate drops substantially, other involvement rates drop, too, and when the federal funds rate rises, other interest rates ascent. However, a fall or ascent of ane percentage point in the federal funds rate—which remember is for borrowing overnight—will typically have an effect of less than one pct point on a 30-year loan to purchase a house or a iii-year loan to purchase a car. Monetary policy can push the entire spectrum of involvement rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.

The Result of Budgetary Policy on Amass Demand

Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of amass demand. Tight or contractionary budgetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce ii components of aggregate demand. Business investment will refuse because it is less attractive for firms to borrow money, and even firms that accept money will notice that, with higher interest rates, it is relatively more than attractive to put those funds in a financial investment than to brand an investment in physical capital. In improver, 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 involvement 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 beneath potential GDP, expansionary budgetary policy can help the economy render to potential GDP. (Effigy) (a) illustrates this situation. This example uses a short-run upwardly-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of E₀ occurs at an output level of 600. An expansionary budgetary policy will reduce involvement rates and stimulate investment and consumption spending, causing the original aggregate demand bend (AD₀) to shift right to AD₁, and so that the new equilibrium (E_one) occurs at the potential Gross domestic product level of 700.

Expansionary or Contractionary Monetary Policy

(a) The economy is originally in a recession with the equilibrium output and price shown at Due east₀. Expansionary budgetary policy will reduce interest rates and shift amass demand to the correct from AD₀ to Advert_ane, 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 Gross domestic product level of output at the equilibrium East₀ and is experiencing pressures for an inflationary rise in the cost level. Contractionary budgetary policy will shift aggregate demand to the left from Advertisement₀ to AD_i, 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 above its potential GDP, a contractionary monetary policy tin can reduce the inflationary pressures for a rising toll level. In (Figure) (b), the original equilibrium (E₀) occurs at an output of 750, which is in a higher place potential Gross domestic product. A contractionary monetary policy volition heighten interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD₀) to shift left to AD₁, so that the new equilibrium (E₁) occurs at the potential Gdp level of 700.

These examples advise that budgetary policy should exist 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 increment and tighten it when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose budgetary policy seeking to end a recession goes besides far, it may push aggregate need then far to the right that information technology triggers inflation. If tight monetary policy seeking to reduce aggrandizement goes too far, it may push amass demand so far to the left that a recession begins. (Figure) (a) summarizes the chain of furnishings that connect loose and tight monetary policy to changes in output and the cost level.

The Pathways of Monetary Policy

(a) In expansionary monetary policy the central bank causes the supply of money and loanable funds to increase, which lowers the interest charge per unit, stimulating additional borrowing for investment and consumption, and shifting aggregate need right. The result is a higher price level and, at least in the curt run, higher real Gross domestic product. (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economic system to decrease, which raises the interest charge per unit, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at to the lowest degree in the brusk run, lower existent GDP.

Federal Reserve Actions Over Last 4 Decades

For the period from the mid-1970s up through the end of 2007, nosotros can summarize Federal Reserve monetary policy past looking at how information technology targeted the federal funds involvement rate using open marketplace operations.

Of class, 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 ix episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the fundamental bank as one of the leading actors influencing the macro economic system. As we noted earlier, the single person with the greatest power to influence the U.Due south. economic system is probably the Federal Reserve chairperson.

(Effigy) shows how the Federal Reserve has carried out budgetary policy by targeting the federal funds interest rate in the last few decades. The graph shows the federal funds interest charge per unit (recollect, this interest rate is set through open market operations), the unemployment rate, and the aggrandizement charge per unit since 1975. Different episodes of budgetary policy during this period are indicated in the effigy.

Budgetary Policy, Unemployment, and Aggrandizement

Through the episodes here, the Federal Reserve typically reacted to higher aggrandizement 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 i

Consider Episode 1 in the late 1970s. The rate of aggrandizement was very loftier, exceeding ten% in 1979 and 1980, and so the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds rate ascension from v.5% in 1977 to xvi.4% in 1981. By 1983, inflation was down to 3.2%, just aggregate demand 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 nine.7% in 1982.

Episode 2

In Episode ii, when economists persuaded the Federal Reserve in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds involvement rate fell from 16.4% in 1981 to 6.eight% in 1986. By 1986 or then, inflation had fallen to about ii% and the unemployment charge per unit had come down to 7%, and was nevertheless falling.

Episode 3

Nonetheless, in Episode iii in the belatedly 1980s, aggrandizement appeared to exist creeping up again, rising from 2% in 1986 up toward five% by 1989. In response, the Federal Reserve used contractionary monetary policy to enhance the federal funds rates from 6.vi% in 1987 to 9.ii% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but it too helped to crusade the 1990-1991 recession, and the unemployment rate rose from 5.3% in 1989 to seven.5% by 1992.

Episode 4

In Episode four, in the early 1990s, when the Federal Reserve was confident that inflation was back under command, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to 3.5% in 1992. As the economic system expanded, the unemployment rate declined from 7.5% in 1992 to less than 5% past 1997.

Episodes 5 and half dozen

In Episodes 5 and six, the Federal Reserve perceived a risk of inflation and raised the federal funds charge per unit from 3% to v.eight% from 1993 to 1995. Aggrandizement did not rise, and the flow of economic growth during the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to exist creeping upwardly so it raised the federal funds interest rate from iv.vi% in Dec 1998 to 6.5% in June 2000. Past early 2001, inflation was failing once more, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from iv.0% to 5.viii%.

Episodes seven and eight

In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds charge per unit from 6.2% in 2000 to simply 1.7% in 2002, and so once more 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 have. The recession ended, merely, unemployment rates were slow to pass up in the early 2000s. Finally, in 2004, the unemployment rate declined and the Federal Reserve began to raise the federal funds rate until information technology reached v% past 2007.

Episode ix

In Episode 9, as the Great Recession took concord in 2008, the Federal Reserve was quick to slash interest rates, taking them downwards to two% in 2008 and to virtually 0% in 2009. When the Fed had taken involvement rates downward to virtually-zero by December 2008, the economy was withal deep in recession. Open market operations could non make the involvement rate plow negative. The Federal Reserve had to think "exterior the box."

Quantitative Easing

The most powerful and commonly used of the three traditional tools of monetary policy—open market place operations—works by expanding or contracting the coin supply in a way that influences the interest charge per unit. In late 2008, as the U.S. economy struggled with recession, the Federal Reserve had already reduced the interest rate to well-nigh-naught. With the recession all the same 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 key banks to brand credit available so as to stimulate aggregate demand.

Quantitative easing differed from traditional budgetary policy in several key ways. Outset, it involved the Fed purchasing long term Treasury bonds, rather than short term Treasury bills. In 2008, even so, it was impossible to stimulate the economy whatever further by lowering brusque term rates considering they were already every bit low as they could get. (Read the closing Bring it Domicile feature for more on this.) Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing.

This leads to a second style 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 washed earlier. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed "toxic assets," because when the housing marketplace collapsed, no one knew what these securities were worth, which put the fiscal institutions which were holding those securities on very shaky basis. By offering to purchase mortgage-backed securities, the Fed was both pushing long term interest rates down and likewise removing perhaps "toxic assets" from the balance sheets of private financial firms, which would strengthen the fiscal organization.

Quantitative easing (QE) occurred in three episodes:

1. During QE_ane, which began in Nov 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.
2. In November 2010, the Fed began QE_ii, in which it purchased $600 billion in U.Southward. Treasury bonds.
3. QE₃, began in September 2012 when the Fed commenced purchasing $40 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 weather let, it volition brainstorm tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final $15 billion bail purchase, ending Quantitative Easing.

We ordinarily 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, then the Federal Reserve volition need to stop making these additional loans and sell off the fiscal securities information technology has accumulated. The concern is that the process of quantitative easing may prove more difficult to opposite than it was to enact. The evidence suggests that QE₁ was somewhat successful, just that QE₂ and QE₃ have been less so.

Fundamental Concepts and Summary

An expansionary (or loose) monetary policy raises the quantity of money and credit above what information technology otherwise would accept been and reduces interest rates, boosting aggregate demand, and thus countering recession. A contractionary monetary policy, likewise called a tight budgetary policy, reduces the quantity of coin and credit beneath what information technology otherwise would have been and raises interest rates, seeking to hold downward inflation. During the 2008–2009 recession, central banks around the world also used quantitative easing to expand the supply of credit.

Cocky-Check Questions

Why does contractionary monetary policy crusade interest rates to rise?

Contractionary policy reduces the amount of loanable funds in the economy. As with all goods, greater scarcity leads a greater price, so the interest charge per unit, or the price of borrowing money, rises.

Why does expansionary budgetary policy causes involvement rates to drib?

An increase in the amount of available loanable funds means that there are more people who want to lend. They, therefore, bid the price of borrowing (the interest rate) downward.

Review Questions

How practise the expansionary and contractionary monetary policy affect the quantity of money?

How do tight and loose budgetary policy affect interest rates?

How practise expansionary, tight, contractionary, and loose monetary policy affect 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.

Critical Thinking Question

A well-known economical model chosen the Phillips Curve (discussed in The Keynesian Perspective affiliate) describes the short run tradeoff typically observed between inflation and unemployment. Based on the discussion of expansionary and contractionary monetary policy, explicate why ane 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 business cycle of economic downturns and upswings

expansionary budgetary policy

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

federal funds charge per unit

the involvement rate at which 1 bank lends funds to some other bank overnight

loose monetary policy

see expansionary budgetary policy

quantitative easing (QE)

the purchase of long term regime and individual mortgage-backed securities past central banks to make credit available in hopes of stimulating aggregate demand

tight monetary policy

encounter contractionary monetary policy

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

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