MAcro CHAPTER 4.6:

CHAPTER SUMMARY

Monetary policy is how the Federal Reserve aims to control interest rates through changes in the money supply. They do this to try to control economic conditions and maintain a healthy level of growth.

When they want to grow aggregate demand, they engage in expansionary monetary policy. When they want to shrink aggregate demand, the use contractionary monetary policy.

There are three different ways that the Fed can control the money supply, and therefore interest rates:

1. Discount Rate: The discount rate is the interest rate banks must pay to borrow from the Fed. This affects how much money banks borrow, so when the Fed raises it, banks borrow less money, decreasing the money supply.

2. Reserve ratio: This is another term for the reserve requirement. When they set this very low, banks can loan out more money, increasing the money supply. When they raise it, banks will loan out less money, decreasing the money supply.

3. Open Market Operations: The Fed buys and sells bonds, just like a company. If they want to decrease the money supply, they can issue new bonds, allowing people to "lend" them money in exchange for interest. They take this money and do nothing with it - it is now removed from the economy. Likewise, if they want to increase the money supply, they can buy bonds back from citizens, who then deposit that money in banks, increasing the money supply.

The chart below summarizes what the Fed might do with each of these tools if it seeks to expand or contract the money supply.

So how can these tools bring an economy back to long-run equilibrium?

If the economy is experiencing a recessionary gap (Graph 1), the Fed will use a combination of these tools to increase the money supply, which causes interest rates to fall (Graph 2). Lower interest rates causes both consumer spending and investment spending to increase, raising aggregate demand, bringing the economy back to long-run equilibrium (Graph 3). This is how expansionary monetary policy works.

They would do the exact opposite for an economy in an inflationary gap. Decreasing the money supply would raise interest rates, shifting AD to the left, bringing the economy back into long-run equilibrium.

In the United States today, though, these tools of monetary policy don't really work this way anymore. Why? Because the United States has shifted from a limited reserves model to an ample reserves model. Here's what that means:

• Limited reserves: A system in which banks loan out all the money they are allowed to.

• Ample reserves: A system in which banks keep some of their excess reserves in the central bank (The Fed) instead of loaning it out.

In 2008, because of the Great Recession, the Federal Reserve started paying interest on reserves for the first time, so banks chose to start keeping some of their money in the Fed. This basically meant that adding more money to M0 wouldn't change anything, because the banks would continue to leave it in the Fed instead of loaning it out.

Here's how it looks on a graph:

The x-axis shows the quantity of money and the y-axis shows the interest rate.

The leftmost part of the curve is flat, at the discount rate - the rate that the Fed charges banks to borrow money from them. If Bank of America tries to charge CitiBank 7% interest for a loan, but the Fed is offering loans for 6%, banks will simply borrow from the Fed instead. So no matter how low the money supply gets, the federal funds rate - the rate that banks charge each other for loans (also the equilibrium rate where demand for money equals supply of money) - will never go above 6%.

The rightmost part of the curve is also flat, at the interest on reserves rate (IORR), which is the interest rate that the Fed will pay banks who keep money with them. Imagine the IORR is 2%, and CitiBank asks Bank of America for a loan, but is only willing to pay 1% interest. In this case, Bank of America will refuse to loan the money to CitiBank, instead keeping their money in the Fed. So, no matter how large the money supply gets, the federal funds rate would never go below 2%.

If the supply of reserves is in either of those two sections, shifting the money supply really has no impact on the interest rate. The interest rate will never go below the IORR and it will never go above the discount rate.

However, if the quantity of money is somewhere in between those sections of the curve, on the downward sloping portion of the demand for money curve, it can influence interest rates, just like in the scarce reserves money market model from Chapter 4.5.

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