Monetary Policy Actions in the Short run

Monetary Policy Actions in the Short Run Examples

We will look at examples of monetary policy actions in the short run to see how the economy is affected.

Monetary Policy Actions in the Short Run: Expansionary Monetary Policy

First, we will see how expansionary monetary policy in the short run affects output and price level in an economy.

Fig 1. - Expansionary Monetary Policy

What does the graph above tell us? The economy is going through a recessionary period at points P1 and Y1. Aggregate demand is below the equilibrium point and must be increased to reach equilibrium. The recession will prompt The Federal Reserve to conduct expansionary monetary policy to achieve its goal. This will result in the money supply increasing and interest rate decreasing to push aggregate demand to the right. This will result in an increase in output and price level. Now, at P2 and Y2, the economy is in a new equilibrium — the Federal Reserve has successfully addressed a recessionary period in the economy!

Monetary Policy Actions in the Short Run: Contractionary Monetary Policy

Now, we will see how contractionary monetary policy in the short run affects output and price level in an economy.

Fig 2. - Contractionary Monetary Policy

What does the graph above tell us? The economy is going through an inflationary period at points P1 and Y1. Aggregate demand is above the equilibrium point and must be decreased to reach equilibrium. Inflation will prompt The Federal Reserve to conduct contractionary monetary policy to achieve its goal. This will result in the money supply decreasing and interest rates increasing to push aggregate demand to the left. This will result in a decrease in output and price level. Now, at P2 and Y2, the economy is in equilibrium — The Federal Reserve has successfully addressed an inflationary period in the economy!

General Effects of Monetary Policy in the Short Run

General effects of monetary policy in the short run will differ based on The Federal Reserve's actions. The Federal Reserve needs to use specific tools to alter the money supply in the economy. We will go over the three tools The Federal Reserve uses to change the money supply.

General Effects of Monetary Policy in the Short Run: Required Reserves

Required Reserves are the amount of money that a bank is required to hold onto in reserves. The Federal Reserve can change the money supply by altering the required reserve requirements. If the reserve requirement is low, then the banks can loan out more of their deposits to consumers — increasing the money supply. If the reserve requirement is high, then the bank cannot loan as much of their deposits to consumers — decreasing the money supply. Generally, more loans in an economy will increase the money supply, whereas fewer loans will decrease the money supply.

General Effects of Monetary Policy in the Short Run: Discount Rate

The Discount Rate is the interest rate that the Federal Reserve charges banks when they borrow from the Federal Reserve. The Federal Reserve can change the money supply by altering the discount rate. If the Federal Reserve decreases the discount rate, then banks can borrow more from The Federal Reserve which results in more loans to consumers — increasing the money supply. If The Federal Reserve increases the discount rate, then banks will borrow less from the Federal Reserve which results in fewer loans to consumers — decreasing the money supply.

General Effects of Monetary Policy in the Short Run: Open-Market Operations

The Federal Reserve buying or selling Treasury bills from commercial banks is known as open-market operations. The Federal Reserve can change the money supply by either buying or selling Treasury Bills. When The Federal Reserve buys Treasury Bills from commercial banks, they are giving money to the banks in exchange for Treasury Bills. This results in banks increasing their reserves by the same amount The Federal Reserve purchases Treasury Bills — increasing the money supply. When The Federal Reserve sells Treasury Bills to commercial banks, they are receiving money from the banks in exchange for Treasury Bills. This results in banks decreasing their reserves by the same amount The Federal Reserve sells Treasury Bills — decreasing the money supply.

Effects of Expansionary Monetary Policy

The Federal Reserve must use expansionary monetary policy to address a recession, but what are the effects of this monetary policy? We will see how expansionary monetary policy affects the economy through required reserves, discount rates, and open-market operations.

Expansionary Monetary Policy Effects: Required Reserves

The Federal Reserve will decrease the reserve requirement for banks. This will allow the banks to increase the amount they can loan to consumers. Recall the money multiplier formula:

The lower the reserve requirement, the stronger the money multiplier will be — increasing the overall money supply. The increase in money supply will then lead to a decrease in interest rates, resulting in an increase in consumer spending and investment. The Federal Reserve successfully increased aggregate demand and can now close the output gap.

Expansionary Monetary Policy Effects: Discount Rate

The Federal Reserve will decrease the discount rate for banks. This will allow banks to borrow more from the Federal Reserve which will increase their reserves. An increase in reserves will allow banks to loan more to consumers — increasing the money supply. The increase in money supply will then lead to a decrease in interest rates, resulting in an increase in consumer spending and investment. The Federal Reserve successfully increased aggregate demand and can now close the output gap.

Expansionary Monetary Policy Effects: Open-market operations

The Federal Reserve will buy Treasury bills from commercial banks. The purchase of Treasury bills will increase the reserves of the commercial banks by the same amount. For example, a $100 billion purchase of Treasury Bills will increase banks' reserves by $100 billion. An increase in reserves will allow banks to loan more to consumers — increasing the money supply. The increase in money supply will then lead to a decrease in interest rates, resulting in an increase in consumer spending and investment. The Federal Reserve successfully increased aggregate demand and can now close the output gap.

Contractionary Monetary Policy Effects

The Federal Reserve must use contractionary monetary policy to address inflation, but what are the effects of this monetary policy? We will see how contractionary monetary policy affects the economy through required reserves, discount rates, and open-market operations.

Contractionary Monetary Policy Effects: Required Reserves

The Federal Reserve will increase the reserve requirement for banks. This will limit the bank's ability to make loans to consumers. Recall the money multiplier formula:

The higher the reserve requirement, the weaker the money multiplier will be — decreasing the overall money supply. The decrease in money supply will then lead to an increase in interest rates, resulting in a decrease in consumer spending and investment. The Federal Reserve successfully decreased aggregate demand and can now close the output gap.

Contractionary Monetary Policy Effects: Discount Rate

The Federal Reserve will increase the discount rate for banks. This will encourage banks to borrow less from the Federal Reserve which will decrease their reserves. A decrease in reserves will limit a bank's ability to loan to consumers — decreasing the overall money supply. The decrease in money supply will then lead to an increase in interest rates, resulting in a decrease in consumer spending and investment. The Federal Reserve successfully decreased aggregate demand and can now close the output gap.

Contractionary Monetary Policy Effects: Open-market operations

The Federal Reserve will sell Treasury bills to commercial banks. The sale of Treasury bills will decrease the reserves of the commercial banks by the same amount. For example, a $50 billion sale of Treasury Bills will decrease banks' reserves by $50 billion. A decrease in reserves will limit the banks' ability to loan to consumers — decreasing the money supply. The decrease in money supply will then lead to an increase in interest rates, resulting in a decrease in consumer spending and investment. The Federal Reserve successfully decreased aggregate demand and can now close the output gap.