How Monetary Policy Works

 

When the Fed changes the money supply, it does so in an attempt to change GDP, unemployment, and inflation. Changing the money supply to bring about changes in GDP, the unemployment rate, and the inflation rate is called monetary policy. In the U.S., the Federal Reserve System (not the President, not the Congress) has the responsibility of carrying out monetary policy.

 

Weíve seen how the Fed can change the size of the money supply, using the three tools of monetary policy (changes in reserve requirements, changes in the discount rate, open market operations). What we need to consider now is how those changes in the money supply work their way through the economy, and what effects they can have on GDP, unemployment, and inflation. The way a change in the money supply works its way through to affect GDP, unemployment, and inflation is called the transmission of monetary policy.

 

This is important stuff.

 

What you should know after reading this section is 1) When should the Fed increase the money supply? 2) How will an in increase in the money supply affect GDP, unemployment, and inflation? 3) When should the Fed reduce the money supply? 4) How will a decrease in the money supply affect GDP, unemployment, and inflation? 5) How much control does the Fed have over the money supply?

 

How Monetary Policy Works: Increasing the Money Supply

Suppose that the Fed increases the money supply. It probably would do so by buying bonds (but the story is the same if it lowers reserve requirements or lowers the discount rate). What happens?

 

When the Fed buys bonds from banks, it gives those banks more reserves. Banks will then try to lend those excess reserves out. But if banks are trying to lend more, they will have to compete with one another to make those loans. How do they compete with one another to make loans? By lowering the interest rate they charge on those loans. (We can also think of this in supply and demand terms: there is an increase in the supply of money to be loaned out, so the price -- which is the interest rate -- will fall.) So the first thing that happens with an increase in the money supply is that interest rates fall.

 

As interest rates fall, businesses are more willing to invest to borrow for investment spending. And consumers, too, are more willing to borrow to buy cars and homes and so on. Thus spending increases. As spending increases, Aggregate Demand increases.

 

 As Aggregate Demand increases, businesses find that their inventories are being run down, so businesses increase their production. But in order to increase their production, they need to hire more workers. So the increase in spending leads to higher GDP and lower unemployment.

 

The increase in spending might also cause businesses to raise prices. Thus increasing the money supply leads to higher inflation, particularly if the economy is already near the full employment level of output.

 

 

To summarize, then: The transmission of monetary policy when the Fed increases the money supply goes like this:

 

1. Fed buys bonds

2. Banks have more reserves

3. As banks compete to lend those excess reserves, interest rates fall

4. As interest rates fall, spending (investment and consumption) goes up

5. As spending goes up, Aggregate Demand increases

6. As Aggregate Demand increases, GDP rises and unemployment falls and inflation increases

 

When would the Fed want to increase the money supply? The increase in the money supply causes spending to rise. We know that increased spending is the key to getting the economy out of recession. So the appropriate time to increase the money supply is when the economy is in a recession.

 

How Monetary Policy Works: Reducing the Money Supply

Suppose that the Fed reduces the money supply. It probably would do so by selling bonds (but the story is the same if it raises reserve requirements or raises the discount rate). What happens?

 

When the Fed sells bonds to banks, it takes away reserves from those banks. Banks will then have fewer reserves to lend out. So then people who want to borrow will have to compete with one another to get those loans. How do borrowers compete with one another to get loans? By raising the interest rate they are willing to pay for on those loans. (We can also think of this in supply and demand terms: there is a decrease in the supply of money to be loaned out, so the price -- which is the interest rate -- will rise.) So the first thing that happens with a decrease in the money supply is that interest rates rise.

 

As interest rates rise, businesses are less willing to invest to borrow for investment spending. And consumers, too, are less willing to borrow to buy cars and homes and so on. Thus spending decreases. As spending decreases, Aggregate Demand goes down.

 

As Aggregate Demand goes down, businesses find that their inventories are piling up in the warehouse, so businesses reduce their production. But as they reduce their production, they donít need as many workers. So the decrease in spending leads to lower GDP and higher unemployment.

 

The decrease in spending might also lead to lower prices, as businesses look to reduce their surplus inventories.

 

To summarize, then: The transmission of monetary policy when the Fed reduces the money supply goes like this:

 

1. Fed sells bonds

2. Banks have fewer reserves

3. Borrowers compete to get fewer loans, so interest rates go up

4. As interest rates go up, spending (investment and consumption) goes down

5. As spending goes down, Aggregate Demand decreases

6. As Aggregate Demand decreases, GDP falls and unemployment rises and inflation decreases

 

When would the Fed want to reduce the money supply? The decrease in the money supply causes spending to fall. We know that decreased spending is the key to reducing inflation. So the appropriate time to increase the money supply is when the economy is experiencing inflation.

 

 

Does the Fed Control the Money Supply?

The Fed has the responsibility for changing the money supply in the US and for carrying out monetary policy. Can the Fed actually control the money supply?

 

The answer, not to keep you in suspense, is ďno, not completely.Ē

 

Banks Matter

To see why, consider what happens when the Fed changes reserve requirements. First, suppose that the Fed raises reserve requirements. Banks must then keep more reserves as cash on hand, and banks are able to lend out less. As banks lend less, the money supply goes down. Do banks have to keep more reserves when the Fed raises reserve requirements? Yes, they do Ė itís the law. So the Fed can make the money supply go down.

 

Now consider what happens when the Fed lowers reserve requirements. Banks donít have to keep as many reserves as cash on hand, so they can make more loans. As banks lend more, the money supply goes up. But do banks have to lend more? Can the Fed make banks lend more? No. The Fed wants banks to lend more, and the Fed can encourage banks to lend more, but the Fed cannot force banks to lend more. So the Fed cannot make the money supply go up, it can only encourage an increase in the money supply.

 

The same thing is true with open market operations. When the Fed buys bonds, it gives banks more reserves. The Fed hopes that banks will lend out those excess reserves, but the Fed cannot force banks to do so. On the other hand, when the Fed sells bonds, it takes banksí reserves away. Banks are then forced to lend less to meet the legal reserve requirements.

 

People Matter Too

Regular people like you and me also play an important role in determining the size of the money supply. If people donít put their money in banks in the first place, banks wonít have anything to lend.

 

So the money supply actually depends on the actions of the Fed, banks, and regular people.

 

Monetary Policy Compared to Fiscal Policy

As we saw earlier, there are problems in carrying out fiscal policy (lags, crowding-out). There are also problems in carrying out monetary policy. One problem, as weíve just seen, is that the Fed doesnít have complete control over what happens when it tries to change the money supply. Another problem is that there are lags with monetary policy, too. It takes time for a change in interest rates to work its way through the economy, for businesses and consumers to change their spending as interest rates change. So the Fed can change the money supply today, but the full effect of that change wonít be felt for at least 5 or 6 months.

 

Itís pretty easy to decide what on the appropriate monetary (or fiscal) policy. In fact, you should be able to do it right now. If the economy is in a recession, increase government spending or cut taxes or increase the money supply. If instead we want to bring down inflation, then cut government spending, raise taxes, or reduce the money supply. That part is easy. But actually getting the policy to work when itís supposed to Ė getting the timing of it right Ė thatís quite difficult.