Definition and goals of monetary policy

Monetary policy refers to the actions taken by a central bank to manage the money supply and interest rates in an economy. These actions aim to achieve specific macroeconomic goals. Central banks, such as the Federal Reserve in the United States, use monetary policy to influence economic conditions and promote stability.

Key goals of monetary policy:

• Price stability - Keeping inflation low and steady to maintain the purchasing power of money.
• Full employment - Supporting economic conditions that minimize unemployment without causing excessive inflation.
• Economic growth - Encouraging sustainable increases in real output and overall economic activity.

Monetary policy focuses on short-run effects, helping to adjust the economy during periods of recession or inflation.

Tools of monetary policy

Central banks have several tools to implement monetary policy. These tools help control the availability of money and credit in the economy. The effectiveness of each tool can vary depending on whether the banking system has limited reserves (low levels of excess bank reserves) or ample reserves (high levels of excess bank reserves, as in the United States).

Main tools of monetary policy:

• Discount rate - The interest rate charged by the central bank on loans to commercial banks. Lowering it encourages borrowing and increases money supply.
• Interest on reserves - The rate paid by the central bank on reserves held by banks. This is the key tool in systems with ample reserves, like the US Federal Reserve.
• Open market operations - The buying or selling of government securities by the central bank to adjust bank reserves.
• Required reserve ratio - The fraction of deposits that banks must hold as reserves. Lowering it allows banks to lend more, expanding the money supply.

These tools are chosen based on the banking system's reserve levels to achieve desired outcomes like changing interest rates or the money supply.

Implementation of monetary policy

The way monetary policy is carried out differs between economies with limited reserves and those with ample reserves. In both cases, the central bank targets key rates to influence broader economic activity.

Implementation in limited reserves systems

In systems with limited reserves, changes in reserves have a multiplied effect on the money supply. For example, an open-market purchase increases reserves and the monetary base, which then expands the money supply through lending.

Formula for money multiplier:

$\text{Money multiplier}=\frac{1}{\text{required reserve ratio}}$

Where:

• Money multiplier - The factor by which the money supply increases due to an initial change in reserves.
• Required reserve ratio - The percentage of deposits banks must hold as reserves.

This multiplier amplifies the impact: if the required reserve ratio is 0.1, the multiplier is 10, meaning a $1 increase in reserves can lead to a $10 increase in money supply.

Implementation in ample reserves systems

In systems with ample reserves, like the US, changes in the money supply do not directly affect nominal interest rates. Instead, the central bank adjusts administered rates, such as interest on reserves, to influence the policy rate.

Key policy rate

Many central banks target a range for an overnight interbank lending rate, known as the policy rate. In the US, this is the federal funds rate, which affects borrowing costs across the economy.

Expansionary and contractionary monetary policies

Monetary policies are classified as expansionary or contractionary based on their goals. These policies address output gaps, which occur when actual output differs from potential output.

Types of output gaps:

• Recessionary gap (negative output gap) - When actual output is below potential, often during a recession, leading to high unemployment.
• Inflationary gap (positive output gap) - When actual output exceeds potential, causing rising prices and inflation.

Expansionary monetary policy

This policy increases the money supply or lowers interest rates to stimulate the economy during a recessionary gap. Actions include open-market purchases or reducing the discount rate. As a result, borrowing becomes cheaper, boosting investment and consumption.

Contractionary monetary policy

This policy decreases the money supply or raises interest rates to cool the economy during an inflationary gap. Actions include open-market sales or increasing interest on reserves. This makes borrowing more expensive, reducing spending and inflationary pressures.

Short-run effects of monetary policy actions

Monetary policy actions have immediate effects on key economic variables in the short run. These effects can be shown using models like the money market model, reserve market model, or aggregate demand-aggregate supply (AD-AS) model. For instance, in the AD-AS model, expansionary policy shifts the aggregate demand curve rightward, increasing real output and the price level.

Effects on economic variables:

• Nominal interest rates - Expansionary policy lowers them; contractionary policy raises them. This influences investment and consumption spending.
• Aggregate demand - Lower interest rates increase aggregate demand by encouraging borrowing and spending.
• Real output - In the short run, expansionary policy boosts output toward full employment.
• Price level - Expansionary policy can raise the price level, while contractionary policy helps lower it.

Central banks influence these through tools like open-market operations: a purchase increases reserves and the monetary base, leading to lower interest rates; a sale has the opposite effect.

Lags in monetary policy

In reality, monetary policy effects are not immediate due to lags. Recognition lag is the time to identify an economic problem, while implementation lag is the time for the economy to adjust to the policy. These lags can delay the full impact on output and prices.

Worked example - Calculating the effect of an open-market purchase with money multiplier

In an economy with limited reserves and a required reserve ratio of 0.2, the central bank conducts an open-market purchase of $500 million in government securities. Calculate the money multiplier and the total increase in the money supply.

Step 1: Identify the values

• Required reserve ratio = 0.2
• Change in reserves (monetary base) = $500 million

Step 2: Calculate the money multiplier

$\text{Money multiplier}=\frac{1}{0.2}=5$

Step 3: Calculate the change in money supply

Change in money supply = change in reserves × money multiplier

Change in money supply = $500 million × 5 = $2,500 million

Step 4: Interpretation

The open-market purchase increases the money supply by $2,500 million, which is greater than the initial $500 million due to the multiplier effect through bank lending.