Which Of The Following Is An Example Of A Tight Money Policy Action?

Chapter 28. Monetary Policy and Bank Regulation

28.iv Monetary Policy and Economic Outcomes

Learning Objectives

By the end of this section, y'all volition exist able to:

• Dissimilarity expansionary monetary policy and contractionary monetary policy
• Explain how budgetary policy impacts interest rates and amass demand
• Evaluate Federal Reserve decisions over the last forty years
• Explain the significance of quantitative easing (QE)

A budgetary policy that lowers interest rates and stimulates borrowing is known equally an expansionary monetary policy or loose monetary policy. 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 volition discuss how expansionary and contractionary monetary policies impact interest rates and amass demand, and how such policies volition bear on macroeconomic goals like unemployment and aggrandizement. Nosotros volition conclude with a look at the Fed'southward monetary policy practice in contempo decades.

The Effect of Budgetary Policy on Involvement Rates

Consider the marketplace for loanable bank funds, shown in Figure i. The original equilibrium (East₀) occurs at an interest rate of 8% and a quantity of funds loaned and borrowed of $x billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (Southward₀) to Due south_one, leading to an equilibrium (E₁) with a lower interest rate of 6% and a quantity of funds loaned of $14 billion. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (South₀) to S₂, leading to an equilibrium (E₂) with a college interest rate of 10% and a quantity of funds loaned of $8 billion.

Figure 1. Budgetary Policy and Interest Rates. The original equilibrium occurs at East₀. An expansionary budgetary policy will shift the supply of loanable funds to the correct from the original supply curve (S₀) to the new supply curve (South₁) and to a new equilibrium of E1, reducing the interest rate from 8% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply bend (South₀) to the new supply (S_two), and raise the involvement rate from 8% to x%.

And so how does a central bank "enhance" involvement rates? When describing the budgetary policy actions taken by a cardinal bank, information technology is common to hear that the central bank "raised involvement rates" or "lowered involvement rates." Nosotros need to be clear most this: more precisely, through open market operations the cardinal bank changes bank reserves in a way which affects the supply bend of loanable funds. As a consequence, interest rates change, every bit shown in Effigy 1. If they practice non meet the Fed's target, the Fed can supply more or less reserves until interest rates practice.

Retrieve that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market place operations.

Of form, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that are to be repaid over different periods of fourth dimension. In general, when the federal funds rate drops substantially, other interest rates driblet, as well, and when the federal funds charge per unit rises, other interest rates rise. However, a fall or ascent of one percentage indicate in the federal funds rate—which remember is for borrowing overnight—volition typically have an result of less than i per centum point on a thirty-year loan to purchase a business firm or a three-year loan to buy a auto. Monetary policy tin button the entire spectrum of interest rates higher or lower, but the specific involvement rates are set by the forces of supply and demand in those specific markets for lending and borrowing.

The Effect of Monetary Policy on Aggregate Demand

Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate need. Tight or contractionary monetary policy that leads to college interest rates and a reduced quantity of loanable funds will reduce two components of amass demand. Business organisation investment will decline considering it is less attractive for firms to borrow money, and even firms that have money volition detect that, with college involvement rates, it is relatively more bonny to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increment business organisation investment and consumer borrowing for big-ticket items.

If the economy is suffering a recession and high unemployment, with output below potential Gross domestic product, expansionary monetary policy tin assistance the economy return to potential Gross domestic product. Figure 2 (a) illustrates this situation. This example uses a short-run up-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of E₀ occurs at an output level of 600. An expansionary monetary policy volition reduce involvement rates and stimulate investment and consumption spending, causing the original aggregate need bend (AD₀) to shift right to AD_i, so that the new equilibrium (East₁) occurs at the potential Gdp level of 700.

Figure 2. Expansionary or Contractionary Budgetary Policy. (a) The economy is originally in a recession with the equilibrium output and price level shown at Eastward₀. Expansionary monetary policy will reduce involvement rates and shift amass demand to the right from AD₀ to AD₁, leading to the new equilibrium (E₁) at the potential Gross domestic product level of output with a relatively modest ascension in the price level. (b) The economy is originally producing above the potential Gdp level of output at the equilibrium E₀ and is experiencing pressures for an inflationary rise in the price level. Contractionary monetary policy will shift amass need to the left from AD₀ to AD₁, thus leading to a new equilibrium (E₁) at the potential Gross domestic product level of output.

Conversely, if an economy is producing at a quantity of output above its potential Gross domestic product, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In Figure 2 (b), the original equilibrium (Eastward₀) occurs at an output of 750, which is above potential Gdp. A contractionary monetary policy will heighten involvement rates, discourage borrowing for investment and consumption spending, and crusade the original demand curve (Ad₀) to shift left to Ad₁, so that the new equilibrium (Eastward₁) occurs at the potential GDP level of 700.

These examples propose that monetary policy should be countercyclical; that is, information technology should act to counterbalance the business cycles of economic downturns and upswings. Monetary policy should be loosened when a recession has acquired unemployment to increase and tightened when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to terminate a recession goes too far, it may push aggregate demand so far to the correct that it triggers inflation. If tight budgetary policy seeking to reduce aggrandizement goes too far, it may push aggregate demand so far to the left that a recession begins. Figure iii (a) summarizes the concatenation of effects that connect loose and tight budgetary policy to changes in output and the cost level.

Figure three. The Pathways of Monetary Policy. (a) In expansionary monetary policy the central bank causes the supply of money and loanable funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and shifting aggregate need right. The consequence is a higher price level and, at least in the short run, higher real Gross domestic product. (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the involvement rate, discouraging borrowing for investment and consumption, and shifting aggregate need left. The result is a lower price level and, at least in the short run, lower existent GDP.

Federal Reserve Actions Over Last Iv Decades

For the period from the mid-1970s up through the terminate of 2007, Federal Reserve monetary policy tin can largely be summed up by looking at how it targeted the federal funds interest rate using open market operations.

Of grade, telling the story of the U.S. economic system since 1975 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and aggrandizement over this fourth dimension. The nine episodes of Federal Reserve activeness outlined in the sections below also demonstrate that the central bank should be considered 1 of the leading actors influencing the macro economy. As noted before, the single person with the greatest power to influence the U.S. economy is probably the chairperson of the Federal Reserve.

Effigy iv 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 charge per unit (remember, this interest rate is fix through open marketplace operations), the unemployment rate, and the inflation rate since 1975. Different episodes of budgetary policy during this period are indicated in the figure.

Effigy 4. Monetary Policy, Unemployment, and Inflation. Through the episodes shown hither, the Federal Reserve typically reacted to higher inflation with a contractionary monetary policy and a higher interest rate, and reacted to higher unemployment with an expansionary monetary policy and a lower involvement charge per unit.

Episode 1

Consider Episode 1 in the tardily 1970s. The charge per unit of inflation was very high, exceeding x% in 1979 and 1980, then the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds rate rise from 5.5% in 1977 to 16.4% in 1981. By 1983, inflation was down to iii.2%, only aggregate demand contracted sharply enough that dorsum-to-back recessions occurred in 1980 and in 1981–1982, and the unemployment rate rose from 5.8% in 1979 to nine.7% in 1982.

Episode 2

In Episode two, when the Federal Reserve was persuaded in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds involvement charge per unit cruel from 16.four% in 1981 to six.viii% in 1986. By 1986 or so, inflation had fallen to about 2% and the unemployment rate had come down to 7%, and was withal falling.

Episode 3

However, in Episode iii in the belatedly 1980s, inflation appeared to exist creeping up again, ascension from 2% in 1986 up toward 5% by 1989. In response, the Federal Reserve used contractionary budgetary policy to enhance the federal funds rates from 6.6% in 1987 to ix.2% in 1989. The tighter monetary policy stopped inflation, which fell from above v% in 1990 to under 3% in 1992, but it too helped to cause the recession of 1990–1991, and the unemployment charge per unit rose from v.iii% in 1989 to vii.5% by 1992.

Episode 4

In Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under command, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to 3.five% in 1992. Equally the economy expanded, the unemployment rate declined from seven.5% in 1992 to less than 5% by 1997.

Episodes v and half dozen

In Episodes five and six, the Federal Reserve perceived a risk of aggrandizement and raised the federal funds rate from 3% to 5.8% from 1993 to 1995. Aggrandizement did not rise, and the flow of economical growth during the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to exist creeping upward and so it raised the federal funds interest rate from 4.6% in December 1998 to six.five% in June 2000. Past early 2001, inflation was declining once again, simply a recession occurred in 2001. Betwixt 2000 and 2002, the unemployment charge per unit rose from 4.0% to 5.8%.

Episodes 7 and viii

In Episodes 7 and 8, the Federal Reserve conducted a loose budgetary policy and slashed the federal funds rate from 6.2% in 2000 to simply 1.7% in 2002, and then again to 1% in 2003. They actually did this considering of fear of Japan-style deflation; this persuaded them to lower the Fed funds further than they otherwise would have. The recession ended, but, unemployment rates were slow to decline in the early 2000s. Finally, in 2004, the unemployment charge per unit declined and the Federal Reserve began to raise the federal funds rate until information technology reached 5% by 2007.

Episode nine

In Episode 9, as the Great Recession took agree in 2008, the Federal Reserve was quick to slash interest rates, taking them down to 2% in 2008 and to nearly 0% in 2009. When the Fed had taken interest rates downwardly to well-nigh-zero past Dec 2008, the economic system was all the same deep in recession. Open up market place operations could not make the interest rate turn negative. The Federal Reserve had to think "exterior the box."

Quantitative Easing

The most powerful and commonly used of the 3 traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate. In late 2008, as the U.S. economy struggled with recession, the Federal Reserve had already reduced the interest rate to almost-zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing (QE). This is the buy of long-term government and private mortgage-backed securities by fundamental banks to make credit available and then as to stimulate aggregate demand.

Quantitative easing differed from traditional monetary policy in several key means. First, it involved the Fed purchasing long term Treasury bonds, rather than short term Treasury bills. In 2008, however, it was impossible to stimulate the economic system any further past lowering short term rates because they were already equally depression equally they could get. (Read the closing Bring it Domicile characteristic for more on this.) Therefore, Bernanke sought to lower long-term rates utilizing quantitative easing.

This leads to a 2d way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something information technology had never washed before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed "toxic assets," because when the housing market collapsed, no i knew what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. Past offering to buy mortgage-backed securities, the Fed was both pushing long term interest rates down and also removing peradventure "toxic assets" from the residual sheets of individual fiscal firms, which would strengthen the financial system.

Quantitative easing (QE) occurred in 3 episodes:

1. During QE_i, which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.
2. In November 2010, the Fed began QE₂, in which it purchased $600 billion in U.S. Treasury bonds.
3. QE_iii, began in September 2012 when the Fed commenced purchasing $twoscore billion of additional mortgage-backed securities per month. This amount was increased in December 2012 to $85 billion per month. The Fed stated that, when economical conditions permit, it will begin tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final $fifteen billion buy of bonds, ending Quantitative Easing.

The quantitative easing policies adopted by the Federal Reserve (and by other central banks effectually the globe) are usually thought of equally temporary emergency measures. If these steps are, indeed, to be temporary, then the Federal Reserve will demand to stop making these additional loans and sell off the fiscal securities it has accumulated. The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact. The evidence suggests that QE₁ was somewhat successful, only that QE₂ and QE_iii have been less and then.

Key Concepts and Summary

An expansionary (or loose) monetary policy raises the quantity of coin and credit higher up what information technology otherwise would have been and reduces interest rates, boosting amass demand, and thus countering recession. A contractionary budgetary policy, too chosen a tight monetary policy, reduces the quantity of coin and credit below what it otherwise would take been and raises involvement rates, seeking to hold downward inflation. During the 2008–2009 recession, central banks around the world too used quantitative easing to aggrandize the supply of credit.

Self-Check Questions

1. Why does contractionary budgetary policy cause interest rates to rising?
2. Why does expansionary monetary policy causes involvement rates to driblet?

Review Questions

1. How do the expansionary and contractionary monetary policy impact the quantity of money?
2. How do tight and loose monetary policy bear on involvement rates?
3. How do expansionary, tight, contractionary, and loose monetary policy touch aggregate demand?
4. Which kind of monetary policy would y'all expect in response to loftier inflation: expansionary or contractionary? Why?
5. Explain how to use quantitative easing to stimulate aggregate demand.

Critical Thinking Questions

A well-known economic model called the Phillips Curve (discussed in The Keynesian Perspective chapter) describes the brusque run tradeoff typically observed between inflation and unemployment. Based on the word of expansionary and contractionary monetary policy, explicate why one of these variables usually falls when the other rises.

Glossary

contractionary budgetary policy

a monetary policy that reduces the supply of money and loans

countercyclical

moving in the reverse direction of the concern cycle of economical downturns and upswings

expansionary monetary policy

a monetary policy that increases the supply of coin and the quantity of loans

federal funds rate

the interest rate at which one depository financial institution lends funds to another bank overnight

loose monetary policy

come across expansionary monetary policy

quantitative easing (QE)

the purchase of long term regime and individual mortgage-backed securities by central banks to make credit bachelor in hopes of stimulating aggregate demand

tight monetary policy

run into contractionary monetary policy

Solutions

Answers to Cocky-Cheque Questions

1. Contractionary policy reduces the amount of loanable funds in the economy. As with all appurtenances, greater scarcity leads a greater price, so the interest rate, or the price of borrowing money, rises.
2. An increment in the amount of bachelor loanable funds means that there are more people who want to lend. They, therefore, bid the price of borrowing (the interest rate) downwards.

Source: https://opentextbc.ca/principlesofeconomics/chapter/28-4-monetary-policy-and-economic-outcomes/

Posted by: peetehiecand.blogspot.com

Share this post