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Monetary Policy Tools for Economic Stability

The document outlines monetary policy tools used by the Federal Reserve to stabilize the economy during recessions and expansions, including interest rates, open market operations, discount rates, and reserve ratios. It explains the effects of these tools on interest rates, price levels, and output, emphasizing the concept of money neutrality. Additionally, it includes graphical analysis and applications related to the AD-AS model and the money market to illustrate the impact of monetary policy decisions.

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Evan Calkins
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71 views6 pages

Monetary Policy Tools for Economic Stability

The document outlines monetary policy tools used by the Federal Reserve to stabilize the economy during recessions and expansions, including interest rates, open market operations, discount rates, and reserve ratios. It explains the effects of these tools on interest rates, price levels, and output, emphasizing the concept of money neutrality. Additionally, it includes graphical analysis and applications related to the AD-AS model and the money market to illustrate the impact of monetary policy decisions.

Uploaded by

Evan Calkins
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Advanced Macroeconomics

Class #18

Learning Goals
●​ Identify and explain monetary policy tools to help stabilize the economy

Recap:

●​ What type of policy should the Fed implement if the economy is in a recession?

Expansionary

●​ What type of policy should the Fed implement if the economy is in an expansion?

Contractionary

Monetary Policy Tools:

●​ Inflation Rates: central banks can set official monetary policy interest rates,
which then affect the interest rates offered by banks to borrowers and savers.
Lowering interest rates can stimulate borrowing and spending, while raising
them can reduce borrowing and spending to control inflation

●​ Open Market Operations: Central banks buy or sell government securities in the
open market to influence the money supply. Purchases inject money into the
economy, while sales withdraw money.

●​ Discount Rate: the lending rate at the Federal Reserve's discount window, where
banks can get a loan if they can't secure funding from another bank on the market

●​ Reserve Ratio: the percentage of a bank's deposits that it's legally required to
hold in reserve, either as cash in its vault or as a deposit at the central bank
Graphical Analysis of Monetary Policy:

Contractionary:

Expansionary:

Zero lower bound: the situation where nominal interest rates cannot fall below zero, as
investors can always earn a zero nominal return by holding cash, limiting central banks'
ability to stimulate the economy through conventional monetary policy
Exploration:
1.​ Assume the country of Quaker Maple is in a recession:
a.​ Draw a graph using the AD-AS model to show this

b.​ Assume the Federal Reserve is going to deploy monetary policy. What
tools are at their disposable and what will they do?
c.​ Graph the impact of your answer on part b below, using both the AD-AS
and money market model. What happens to interest rates? Price level?
Output?

Interest rates decrease


Price level increases
output increases

d.​ Given your answer in part c, what will happen in the long-run?

There will be higher inflation. The economy will be at full employment. The real GDP
will remain the same.

What is money neutrality?

A theory that, in the long run, changes in the money supply only affect nominal
variables like prices and wages, and not real variables like output and employment
Application:

The economy is in a recession with high unemployment and low output.

a.​ Draw a graph of aggregate demand and aggregate supply to illustrate the current
situation. Be sure to include the aggregate demand curve, the short-run aggregate
supply curve, and the long-run aggregate supply curve.

b.​ Identify an open-market operation that would restore the economy to its natural
rate.

The central bank purchases government bonds from the public


c.​ Draw a graph of the money market to illustrate the effect of this open-market
operation. Show the resulting change in the interest rate.

Interest rates decrease from r1 to r*

d.​ Draw a graph similar to the one in part (a) to show the effect of the open-market
operation on output and the price level. Explain in words why the policy has the
effect that you have shown in the graph.

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