4.6 Monetary Policy

a. Define monetary policy and related terms. b. Explain (using graphs as appropriate) the short-run effects of a monetary policy action. c. Calculate (using data and balance sheets as appropriate) the effects of a monetary policy action.

• Central banks implement monetary policies to achieve macroeconomic goals, such as price stability.
• The tools of monetary policy may include the central bank’s discount rate and other administered interest rates (e.g., interest on reserves), open market operations, and the required reserve ratio. The tools used and the way in which they are implemented differ between economies that have limited reserves in their banking system and economies that have ample reserves in their banking system. (The banking system in the United States has ample reserves, and the Federal Reserve’s key policy tool is interest on reserves.)
• When the central bank conducts an open-market purchase (sale), reserves increase (decrease), thereby increasing (decreasing) the monetary base.
• When the central bank conducts an open-market purchase (sale) in an economy with limited reserves, the effect on the money supply is greater than the effect on the monetary base because of the money multiplier.
• Many central banks carry out policy to hit a target range for an overnight interbank lending rate, sometimes referred to as the central bank’s policy rate. (In the United States, this is the federal funds rate.)
• Central banks can influence the nominal interest rate in the short run, which in turn will affect investment and consumption. [See also EK MKT-5.G.2 for the influence on net capital inflows.] In an economy with limited reserves, the central bank can influence the nominal interest rate by changing the money supply. In an economy with ample reserves, changes in the money supply do not effectively change the nominal interest rate; instead, the central bank can influence the nominal interest rate by changing its administered interest rates.
• Expansionary or contractionary monetary policies are used to restore full employment when the economy is in a negative (i.e., recessionary) or positive (i.e., inflationary) output gap.
• Monetary policy can influence interest rates, aggregate demand, real output, and the price level. [See also EK MKT-5.E.3 for the effect on exchange rates.]
• A money market model, a reserve market model, and/or the AD–AS model may be used to demonstrate the short-run effects of monetary policy.
• Enduring understanding POL-1: Fiscal and monetary policy have short-run effects on macroeconomic outcomes.

Define why there are lags to monetary policy.

• In reality, there are lags to monetary policy caused by the time it takes to recognize a problem in the economy and the time it takes the economy to adjust to the policy action.
• Enduring understanding POL-1: Fiscal and monetary policy have short-run effects on macroeconomic outcomes.