Monetary Policy and the Money Market

Introduction to Monetary Policy

• Definition: Policy employed by a central bank to influence the economy.
• Contrast with Fiscal Policy: Involves government decisions on taxation and spending.

Money Market Model Review

• Axes:
  • Horizontal: Quantity of money (e.g., M1 - cash in circulation, checkable deposits).
  • Vertical: Nominal interest rate.
• Assumptions:
  • Perfectly inelastic money supply (vertical line).
• Demand Curve:
  • High nominal interest rates lead to low cash holdings (high opportunity cost).
  • Low nominal interest rates lead to high cash holdings (low opportunity cost).
• Equilibrium: Intersection of supply and demand curves determines nominal interest rate.

Central Bank Actions in a Recession

• Objective: Lower interest rates to increase borrowing, investment, and consumption.
• Method: Increase the money supply by shifting the vertical supply line right.

Tools for Increasing Money Supply

Open Market Operations

• Definition: Primary tool used by central banks.
• Process:
  • Central bank buys bonds, injecting new cash into circulation.
  • Digital transactions often replace physical cash.
• Impact:
  • Multiplier effect based on reserve requirements.
  • Example: $1,000 bond purchase with 12.5% reserve requirement results in $8,000 increase in money supply.

Changing Reserve Requirements

• Less frequently used but affects multiplier and money supply.
• Example: Changing requirement from 12.5% to 10% increases the multiplier effect.

Discount Rate

• Role: Safety mechanism for banks, less for active monetary policy.
• Discount Window: Used during emergencies for banks needing reserves.

Federal Funds Rate

• Target: Set by central banks for overnight interbank lending rates.
• Implementation: Achieved through open market operations.

Adjusting Money Supply in an Inflationary Gap

• Objective: Increase interest rates to slow down the economy.
• Method: Sell bonds to reduce money supply and raise rates.

Lags in Monetary Policy

• Recognition Lag: Time to identify economic conditions (recession or inflation).
• Implementation Lag: Time for policy actions to take effect on interest rates and economic activity.