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Frequently Asked Questions—Part 5
By : Lynn Huselton
Plano East Senior High
Plano, TX
Q.How does monetary policy slow or stimulate economic growth?
A.Monetary policy is conducted by the nation's central bank, the Federal Reserve. Monetary policy consists of the manipulation of three tools, required reserves, discount rate and the open market operations. The required reserves is money that the Federal Reserve requires all banks to keep in their vault or at the Federal Reserve. The discount rate is the interest that banks must pay when they borrow from the Fed. The open market operations is the buying and selling of bonds. If the economy is experiencing demand-pull inflation during a normal expansion of the business cycle, the Fed may decide to increase the required reserves, increase the discount rate and/or sell bonds. When any one of these three things are done, the banks will actually have less money to loan. Having less money to loan will cause a decrease in the expansion capability of the banks. Thus interest rates will increase. Because interest rates are now at a higher level, businesses will demand less money for investment (building factories). When businesses stop purchasing machines, tools and factories, the aggregate demand in the economy decreases. A decrease in aggregate demand results in a lower price level, lower output and lower employment. If the economy is experiencing an increase in cyclical unemployment, the Federal Reserve may choose to decrease the required reserve, decrease the discount rate and/or buy bonds. This will cause banks to have more money to loan. The money expansion capability of the banks will increase. As a result interest rates will decrease. With lower interest rates, the businesses will find it more profitable to borrow money for the purchase of tools, machines, and factories. This increased business investment will increase aggregate demand and put pressure upward on prices. Also, the output and the employment in the economy will increase.
The following is a line of code that may help your students remember the cause effect actions of the Federal Reserve when they pursue monetary policy. To fight demand-pull inflation the Federal Reserve would use contractionary monetary policy:
The opposite of the above would be true for expansionary to easy money policy.
There are limitations to the use of monetary policy. The Federal Reserve should coordinate its monetary policy with the fiscal policy of the government. If this is not done, the two policies could cancel one another. Another limitation would be forecasting and time lags. It is difficult to predict the direction of the economy. A wrong prediction could make a problem worse. Time lags refer to the length of time it takes for an easy money or expansionary monetary policy to take effect. If the business cycle is currently in a severe downturn and the Federal Reserve pursues an easy money or expansionary monetary policy placing more money in the banks, banks may choose not to loan this money for fear businesses are a bad risk at this time. This decision by the banks to not loan all their money wold limit the ability of the Federal Reserve to expand the economy.
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