4.6 Monetary Policy

The Fed's Tools

The Federal Reserve controls the money supply using: open market operations (buying/selling bonds), the reserve requirement (% of deposits banks must hold), and the discount rate (interest rate the Fed charges banks). Buying bonds, lowering reserve requirements, or lowering the discount rate all increase the money supply.

Expansionary vs. Contractionary

Expansionary monetary policy increases money supply, lowering interest rates, boosting investment/consumption, shifting AD right — used to fight recession/unemployment. Contractionary monetary policy decreases money supply, raising interest rates, reducing spending, shifting AD left — used to fight inflation.

Money Market & Interest Rates

In the money market, money supply is vertical (fixed by the Fed) and money demand slopes downward. An increase in money supply lowers the nominal interest rate; a decrease raises it. This interest rate change affects investment spending via the loanable funds/investment demand relationship, ultimately shifting AD.

Key terms

Open market operations

The Fed's buying/selling of government bonds to change the money supply; the most commonly used monetary policy tool.

Reserve requirement

The percentage of deposits banks must hold rather than lend out; lowering it increases the money supply.

Discount rate

The interest rate the Federal Reserve charges commercial banks for loans.

Expansionary monetary policy

Increases money supply, lowers interest rates, increases investment/consumption, shifts AD right; used to fight recession.

Contractionary monetary policy

Decreases money supply, raises interest rates, decreases investment/consumption, shifts AD left; used to fight inflation.

Try an AP-style question

To fight a recession, the Fed would…

1. raise the discount rate
2. raise reserve requirements
3. buy government bonds
4. sell government bonds