In late , as the U. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing QE. This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand. Quantitative easing differed from traditional monetary policy in several key ways.
First, it involved the Fed purchasing long term Treasury bonds , rather than short term Treasury bills. In , however, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get. Read the closing Bring it Home feature for more on this. Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing.
This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. We usually think of the quantitative easing policies that the Federal Reserve adopted as did other central banks around the world as temporary emergency measures.
If these steps are to be temporary, then the Federal Reserve will need to stop making these additional loans and sell off the financial securities it has accumulated. The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact. An expansionary or loose monetary policy raises the quantity of money and credit above what it otherwise would have been and reduces interest rates, boosting aggregate demand, and thus countering recession.
A contractionary monetary policy, also called a tight monetary policy, reduces the quantity of money and credit below what it otherwise would have been and raises interest rates, seeking to hold down inflation. During the — recession, central banks around the world also used quantitative easing to expand the supply of credit. Contractionary policy reduces the amount of loanable funds in the economy. As with all goods, greater scarcity leads a greater price, so the interest rate, or the price of borrowing money, rises.
An increase in the amount of available loanable funds means that there are more people who want to lend. They, therefore, bid the price of borrowing the interest rate down. How do the expansionary and contractionary monetary policy affect the quantity of money? How do expansionary, tight, contractionary, and loose monetary policy affect aggregate demand? Which kind of monetary policy would you expect in response to high inflation: expansionary or contractionary?
A well-known economic model called the Phillips Curve discussed in The Keynesian Perspective chapter describes the short run tradeoff typically observed between inflation and unemployment. Based on the discussion of expansionary and contractionary monetary policy, explain why one of these variables usually falls when the other rises.
Skip to content Monetary Policy and Bank Regulation. These examples suggest that monetary policy should be countercyclical ; that is, it should act to counterbalance the business cycles of economic downturns and upswings. Monetary policy should be loosened when a recession has caused unemployment to increase and tightened when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation.
If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. Figure 3 a summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level.
For the period from the mids up through the end of , Federal Reserve monetary policy can largely be summed up by looking at how it targeted the federal funds interest rate using open market operations. Of course, telling the story of the U.
The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that the central bank should be considered one of the leading actors influencing the macro economy. As noted earlier, the single person with the greatest power to influence the U. Figure 4 shows how the Federal Reserve has carried out monetary policy by targeting the federal funds interest rate in the last few decades.
The graph shows the federal funds interest rate remember, this interest rate is set through open market operations , the unemployment rate , and the inflation rate since Different episodes of monetary policy during this period are indicated in the figure. Consider Episode 1 in the late s. By , inflation was down to 3. In Episode 2, when the Federal Reserve was persuaded in the early s that inflation was declining, the Fed began slashing interest rates to reduce unemployment.
The federal funds interest rate fell from In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6. In Episode 4, in the early s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.
As the economy expanded, the unemployment rate declined from 7. Inflation did not rise, and the period of economic growth during the s continued. Then in and , the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4. By early , inflation was declining again, but a recession occurred in Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy or tight monetary policy.
This module will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. Consider the market for loanable bank funds, shown in Figure Figure As a result, interest rates change, as shown in Figure The restriction or expansion of available funds can influence purchasing trends, inflation and production levels.
Understanding the economic theories behind tight and loose monetary policies, including the implications of such policies, can help small businesses better prepare for the ebbs and flows related to the business cycle.
The Federal Reserve pays close attention to the health of the economy as a whole and implements monetary policy to help increase the money supply during a downturn and restrict the money supply during periods of excessive growth.
Monetary policy actions include those related to reserve requirements, discount rates and transactions involving government securities. According to the Federal Reserve Bank of Dallas , the Federal Reserve's only direct link to the economy is through the country's capital markets, which it does by influencing the supply of available money.
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