Monetary Policy - Key Concepts and Tools

Monetary Policy

Introduction

  • Monetary policy is controlled by central banks like the Federal Reserve (The Fed) in the U.S. or the European Central Bank (ECB) in Europe. These banks:
    • Regulate commercial banks.
    • Oversee national banks by ensuring sufficient reserves to prevent bank runs.
    • Conduct monetary policy by adjusting the money supply to influence the economy's speed.

Interest Rates

  • Interest rate: The price of borrowing money.
    • Banks lend money expecting repayment of principal (the amount lent) and interest (a percentage of the principal).
    • Interest covers inflation and provides profit to the bank.
  • Low interest rates:
    • Encourage borrowing and spending/investment because loans are easier to pay back.
  • High interest rates:
    • Discourage borrowing and spending/investment.
  • The Fed influences interest rates by manipulating the supply of money.
    • Increased money supply: Banks compete for borrowers, lowering interest rates (Expansionary Monetary Policy).
    • Decreased money supply: Banks seek higher interest rates due to scarcity of funds (Contractionary Monetary Policy).

Expansionary Monetary Policy

  • Objective: To speed up the economy.
  • Method: Increase the money supply, which leads to lower interest rates, increased borrowing, and increased spending.

Contractionary Monetary Policy

  • Objective: To slow down the economy.
  • Method: Decrease the money supply, which leads to increased interest rates and decreased spending.

Real-Life Examples

  • Post Dot Com bust and 9/11: The U.S. economy experienced a recessionary gap (low output, high unemployment).
    • The Fed increased the money supply, lowering interest rates.
    • This made borrowing easier, boosting spending, which led to economic growth.
  • Late 1970s: High inflation (up to 13% per year).
    • Paul Volcker (Fed Chairman) decreased the money supply, causing interest rates to rise.
    • This reduced inflation but increased unemployment.
  • The Great Depression: The Fed failed to provide emergency loans to banks, causing bank failures and prolonging the depression.
    • Banks lacked liquid assets (cash) to meet depositor demands during bank runs.

How Central Banks Change the Money Supply

  • Fractional Reserve Banking: Banks hold a percentage of deposits (reserve requirement) and loan out the rest.
  • Reserve Requirement: The fraction of deposits banks must hold in reserve.
    • Decreasing the reserve requirement increases the money supply.
    • Increasing the reserve requirement decreases the money supply.
  • Discount Rate: The interest rate at which commercial banks can borrow money directly from the Fed.
    • Decreasing the discount rate increases the money supply.
    • Increasing the discount rate decreases the money supply.
  • Open Market Operations: The Federal Reserve buys or sells short-term government bonds (treasury bills).
    • Buying bonds increases the money supply.
    • Selling bonds decreases the money supply.
    • Decisions on buying and selling bonds are made by the Federal Open Market Committee.

Quantitative Easing (Q.E.)

  • Involves central banks buying longer-term assets (e.g., mortgage-backed securities) from banks.
  • Used during the 2008 financial crisis to boost the money supply and drop interest rates to near zero.
  • The Fed used "made-up money" to purchase assets.
  • Concerns: Can lead to inflation.

Inflation

  • Milton Friedman: "Inflation is always and everywhere a monetary phenomenon."
  • Excess Reserves: The amount banks can loan out beyond the reserve requirement.
    • Since 2008, excess reserves have increased dramatically, meaning banks held onto money instead of lending it.
  • Reasons for high excess reserves and low inflation:
    • Stricter lending regulations.
    • Increased fear of taking on debt.
    • Economic uncertainty in Europe causing foreigners to hold dollars.
    • Sputtering economy.

Fiscal Policy vs. Monetary Policy

  • Fiscal Policy: Changes in government spending or taxes.
  • Monetary Policy: Changes in the money supply.
  • Monetary policy is generally more effective for garden-variety economic fluctuations because:
    • It is enacted quickly by experts.
    • These experts focus solely on the state of the economy.
  • Fiscal policy may be more effective in a severe downturn.
  • The U.S. used both in 2008.
  • The effectiveness of monetary policy depends on the central bank's isolation from political influence.