Monetary policy, part 1

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Let’s begin by defining monetary policy.

Monetary policy: The actions taken by the central bank to affect GDP, the rate of inflation, and levels of unemployment. These actions primarily involve raising or lowering interest rates.

A monetary policy that lowers interest rates and stimulates borrowing is an expansionary or loose monetary policy. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary or tight monetary policy.

Recall the factors that will shift aggregate demand (listed in tables 1a and 1b). One is lowering interest rates, which will increase aggregate demand by increasing consumption and investment spending. Raising interest rates will do the opposite: decrease aggregate demand by decreasing consumption and investment spending.

An increase in aggregate demand, as you know, will increase GDP and lower unemployment (and also increase the price level). A decrease in aggregate demand will lower the price level (and also decrease GDP and raise unemployment).

Thus, if the Fed can raise or lower interest rates (which it can), then it can increase or decrease aggregate demand and affect GDP, unemployment, and the price level.

Figure 1  Expansionary monetary policy (left) seeks to shift the aggregate demand curve to the right and thereby increase GDP. Contractionary monetary policy (right) seeks to shift the aggregate demand curve to the left, thus, decreasing GDP and lowering the price level.
How does the Fed control interest rates?

We have already encountered the supply and demand for loanable funds (figure 2). Loanable funds—that is, money that is used to make loans—is on the horizontal axis. The price put on money that is used for loans, an interest rate, is on the vertical axis.

Figure 2  If the supply of loanable funds increases (left), then the interest rate will decrease. If the supply of loanable funds decreases (right), then the interest rate will increase.

So, if the Fed can increase or decrease the supply of loanable funds, then it will be able to affect interest rates. Changing the interest rate, in turn, will affect aggregate demand. The Fed can do this, and we will look at two of the ways that it can (there are more than two, but we’ll focus on two): (1) by changing the reserve requirement and (2) by buying and selling bonds.

Changing the reserve requirement

One way that the Fed can change interest rates is by changing the reserve requirement for all banks.

Given a reserve requirement and an amount of money that a bank is holding in reserve, the money multiplier formula tells us how high the bank’s deposits can get. The level deposits, then, will determine how much money is available to be used as loans.

As we will see, with a lower the reserve requirement, deposits can get higher and banks will be required to hold a smaller percentage of these deposits as reserves. Hence, a lower reserve requirement will increase the supply of loanable funds.

On the other hand, a higher reserve requirement means that deposits cannot get as high and banks have to hold a larger percentage of these deposits in reserve. Therefore, a higher reserve requirement will decrease the supply of loanable funds.

A 10% reserve requirement

As we have seen, if the reserve requirement is 10% and a bank has $1,000 in its reserves, then its deposits can reach $10,000.

\[\mathsf{\frac{1}{.10} \times \$ 1000 = 10 \times \$ 1000 = \$ 10,000}\]

If the bank is holding $1,000 in its reserves and has $10,000 in deposits, it can loan $9,000.

assets liabilities
reserves $1,000 deposits $10,000
loans $9,000
total $10,000 total $10,000

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An 8% reserve requirement

If, however, the Federal Reserve lowers the reserve requirement to 8 percent, then banks won’t have to hold as much money in reserves, and they can increase their lending. (They don’t have to increase it, but they can; and since banks make money by making loans, they tend to loan as much as they can—although there are sometimes factors that make them more cautious.)

Now, if the bank in our example makes the maximum allowable amount of loans, deposits can increase to $12,500:

\[\mathsf{\frac{1}{.08} \times \$ 1000 = 12.5 \times \$ 1000 = \$ 12,500}\]

The amount that is held in the bank’s reserves hasn’t changed. It’s still $1,000. But now, the bank can make loans totaling $11,500. In other words, the supply of loanable funds has increased.

assets liabilities
reserves $1,000 deposits $12,500
loans $11,500
total $12,500 total $12,500
A 12% reserve requirement

Alternatively, if the Fed raises the reserve requirement to 12 percent, then the money supply in our example will fall to $8,333:

\[\mathsf{\frac{1}{.12} \times \$ 1000 = 8.333 \times \$ 1000 = \$ 8,333}\]

Consequently, the bank can only loan $7,333. Thus, the supply of loanable funds has decreased.

assets liabilities
reserves $1,000 deposits $8,333
loans $7,333
total $8,333 total $8,333
Interest rates and borrowing

When the supply of loanable funds increases (which means that the supply curve shifts to the right), interest rates will fall. (See figure 2 above.) This will increase borrowing by firms and consumers. When firms increase their borrowing, it allows them to increase spending on factories and equipment. When consumers increase borrowing, it is typically so that they can purchase homes, cars, and other “big ticket” items.

This increase spending by firms and consumers shifts the aggregate demand curve to the right, which increases GDP.

When the supply of loanable funds decreases (which means that the supply curve shifts to the left), interest rates will rise. This will decrease borrowing by firms and consumers, which, in turn, will decrease spending on the types of items just mentioned.

This decrease in purchasing by firms and consumers shifts the aggregate demand curve to the left, which decreases GDP. It also lowers the price level, which might be the Fed’s goal if inflation is high.


The money supply

When we began this banking example, we said that $1,000 was all of the money in this town and no money was entering or leaving (or being created). Thus, the amount of deposits held by this bank is the entire money supply in this town. In reality, banks don’t hold the entire money supply. There will always be some currency that is not in banks. But nonetheless, a significant portion of the money supply is in banks.

Thus, when the Federal reserve affects the amount of deposits, it is affecting the money supply.