Download Define and Discuss on Monetary Policy

Define and Discuss on Monetary Policy
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Monetary policy is conducted by a nation's central bank. In the U.S., monetary policy is
carried out by 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 rate. Recall from the earlier discussion of money and
banking that open market operations involve Fed purchases and sales of U.S. government
bonds. When the Fed purchasesgovernment bonds, it increases the reserves of the
banking sector, and by the multiple deposit expansion process, the supply of
money increases. When the Fedsells some of its stock of U.S. government 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 time, unanticipated withdrawals
leave banks with insufficient reserves. Banks can make up for 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. Accordingly, banks will hold more excess reserves,
which tends to reduce the multiple expansion of deposits and the supply of money.
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 anincrease in the
supply of money.
Expansionary
and
contractionary
monetary
policy. The
Fed
is
engaging
inexpansionary 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 its instruments to effect a reduction in
the supply of money. Classical view of monetary policy. The classical economists' view
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of monetary policy is based on the quantity theory of money. According to this theory, an
increase (decrease) in the quantity of money leads to a proportional increase (decrease) in
the price level. The quantity theory of money is usually discussed in terms of
the equation of exchange, which is given by the expression
In this expression, P denotes the price level, and Y denotes the level of current real GDP.
Hence, PY represents current nominal GDP; M denotes the supply of money over which
the Fed has some control; and V denotes the velocity of circulation, which is the average
number of times a dollar is spent on final goods and services over the course of a year.
The equation of exchange is an identity which states that the current market value of all
final goods and services—nominal GDP—must equal the supply of money multiplied by
the average number of times a dollar is used in transactions in a given year. The quantity
theory of money requires two assumptions, which transform the equation of exchange
from an identity to a theory of money and monetary policy.
Recall that the classical economists believe that the economy is always at or near the
natural level of real GDP. Accordingly, classical economists assume that Y in the
equation of exchange is fixed, at least in the short‐run. Furthermore, classical economists
argue that the velocity of circulation of money tends to remain constant so that V can also
be regarded as fixed. Assuming that both Y and V are fixed, it follows that if the Fed were
to engage in expansionary (or contractionary) monetary policy, leading to an increase (or
decrease) in M, the only effect would be to increase (or decrease) the price level, P, in
direct proportion to the change in M. In other words, expansionary monetary policy can
only lead to inflation, and contractionary monetary policy can only lead to deflation of
the price level.
Keynesian view of monetary policy. Keynesians do not believe in the direct link
between the supply of money and the price level that emerges from the classical quantity
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theory of money. They reject the notion that the economy is always at or near the natural
level of real GDP so that Y in the equation of exchange can be regarded as fixed. They
also reject the proposition that the velocity of circulation of money is constant and can
cite evidence to support their case.
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, however, remain skeptical about the effectiveness of monetary policy. They
point out that expansionary monetary policies that increase the reserves of the banking
system need not lead to a multiple expansion of the money supply because banks can
simply refuse to lend out their excess reserves. Furthermore, the lower interest rates that
result from an expansionary monetary policy need notinduce an increase in aggregate
investment and consumption expenditures because firms' and households' demands for
investment and consumption goods may not be sensitive to the lower interest rates. For
these reasons, 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.
Monetarist view of monetary policy. Since the 1950s, a new view of monetary policy,
called monetarism, has emerged that disputes the Keynesian view that monetary policy
is relatively ineffective. Adherents of monetarism, calledmonetarists, argue that
the demand for money is stable and is not very sensitive to changes in the rate of interest.
Hence, expansionary monetary policies only serve to create a surplus of money that
households will quickly spend, thereby increasing aggregate demand. Unlike classical
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economists, monetarists acknowledge that the economy may not always be operating at
the full employment level of real GDP. Thus, in the short‐run, monetarists argue that
expansionary monetary policies may increase the level of real GDP by increasing
aggregate demand. However, in the long‐run, when the economy is operating at the full
employment level, monetarists argue that the classical quantity theory remains a good
approximation of the link between the supply of money, the price level, and the real
GDP—that is, in the long‐run, expansionary monetary policies only lead to inflation and
do not affect the level of real GDP.
Monetarists are particularly concerned with the potential for abuse of monetary policy
and destabilization of the price level. They often cite the contractionary monetary policies
of the Fed during the Great Depression, policies that they blame for the tremendous
deflation of that period. Monetarists believe that persistent inflations (or deflations) are
purely monetary phenomena brought about by persistent expansionary (or contractionary)
monetary policies. As a means of combating persistent periods of inflation or deflation,
monetarists argue in favor of a fixed money supply rule. They believe that the Fed
should conduct monetary policy so as to keep the growth rate of the money supply fixed
at a rate that is equal to the real growth rate of the economy over time. Thus, monetarists
believe that monetary policy should serve to accommodate increases in real GDP without
causing either inflation or deflation.
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