Monetary Policy

Monetary policy is conducted by a nation's central bank. In the U.S. monetary policy is carried out by the Federal Reserve Bank frequently referred to us "the Fed." The Fed has three main instruments that it uses to conduct monetary policy: open market operations, changes in reserve requirements, and changes in the discount rates. Open market operations involve Fed purchases and sales of U.S. government bonds. When the Fed purchases government bonds, it increases the reserves of the banking sector, and by the multiple deposit expansion process, the supply of money increases. When the Fed sells some of its stock of bonds, the end result is a decrease in the supply of money. If the Fed increases bank reserve requirements, the banking sector's excess reserves are reduced, leading to a reduction in the supply of money; a decrease in reserve requirements induces an increase in the supply of money.

The discount rate is the interest rate the Fed charges banks that need to borrow reserves in order to meet reserve requirements. From time to

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time, unanticipated withdrawals leave banks with insufficient reserves. Banks can make up deficiencies in their required reserves by borrowing from the Fed at the discount rate. If the Fed sets the discount rate high relative to market interest rates, it becomes more costly for banks to fall below reserve requirements. Similarly, when the discount rate is low relative to market interest rates, banks tend to hold fewer excess reserves, allowing for greater deposit expansion and an increase in the supply of money.

The Fed is engaging in expansionary monetary policy when it uses any of its instruments of monetary policy in such a way as to cause an increase in the supply of money. The Fed is said to engage in contractionary monetary policy when it uses it instruments to effect a reduction in the supply of money.

Kcvnesian and classical views of monetary policy. Keynesians do believe in an indirect link between the money supply and real GDP. They believe that expansionary monetary policy increases the supply of loanable funds available through the banking system, causing interest rates to fall. With lower interest rates, aggregate expenditures on investment and interest-sensitive consumption goods usually increase, causing real GDP to rise. Hence, monetary policy can affect real GDP indirectly. Keynesians tend to place less emphasis on the effectiveness of monetary policy and more emphasis on the effectiveness of fiscal policy, which they regard as having a more direct effect on real GDP. The classical economists believe that an increase (decrease) in the quantity of money leads to a proportional increase (decrease) in the price level. Their view is that expansionary monetary policy can only lead to inflation, and contractionary monetary policy can only lead to deflation of the price level.

Monetarist view on monetary policy. Since the 1950s, a new view of monetary policy, called monetarism, has emerged. Monetarists believe that persistent Inflations (or delations) are purely monetary phenomena brought about by persistent expansionary (or contractionary) policies. Their view is that monetary policy should serve to accommodate increases in real GDP without causing either inflation or deflation.