(3) Monetary Policy- Macro 4.6

Overview of Monetary Policy

  • Money Market Graph: Illustrates the supply and demand for money, determining the equilibrium nominal interest rate.

  • Impact of Interest Rate:

    • Affects investment spending and consumer spending on interest-sensitive goods.

    • Increase in money supply leads to lower interest rates, stimulating investment and spending.

    • Decrease in money supply results in higher interest rates, reducing investment and spending.

  • Definition: Controlling the money supply to affect interest rates is termed monetary policy.

How the Central Bank Changes the Money Supply

  • Key Distinctions:

    • Monetary Base: Composed of bank reserves (not part of money supply) and currency in circulation (part of money supply).

    • Money Supply: Includes checkable deposits, which are funds in checking accounts that can be used for transactions.

  • Money Multiplier: Ratio of monetary base to money supply, indicating how much the money supply can increase based on the reserve requirement.

Three Methods of Changing the Money Supply

  1. Changing the Reserve Requirement:

    • Lowering the reserve requirement (from 20% to 10%):

      • Example: A $100 cash deposit results in $90 excess reserves available for loans.

      • The bank can generate up to $900 from the initial deposit through the money creation process.

    • Conclusion: Altering reserve requirements impacts the money supply by affecting the money multiplier.

  2. Adjusting the Discount Rate:

    • Discount Rate: The interest rate the central bank charges banks for loans.

    • Lowering the discount rate makes borrowing cheaper:

      • Encourages banks to take out more loans from the central bank.

      • Increases monetary base and money supply, leading to decreased interest rates and increased spending.

  3. Open Market Operations:

    • Definition: Involves the central bank buying or selling government bonds from/to commercial banks.

    • Buying Bonds:

      • Increases reserves in banks, enhancing liquidity for loans.

      • For example, purchasing a $100 treasury bond increases bank reserves, leading to a potential total increase in money supply by $1,000 through subsequent loans.

    • Selling Bonds:

      • Decreases reserves and the money supply, as banks have less to lend out.

    • Key Takeaway: To increase the money supply, the central bank must buy bonds; to decrease it, they must sell bonds.

Other Changes to Money Supply

  • Quantitative Easing: While not covered in depth, involves the central bank buying various assets (e.g., mortgages, car loans) beyond just bonds.

Real-World Considerations

  • Monetary policy is complex and assumes banks hold no excess reserves.

  • In practice, banks may not fully loan out reserves, making real-world applications more intricate.

Conclusion and Additional Resources

  • Understanding monetary policy as a mechanism to influence interest rates through the money supply is crucial for economic literacy.

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