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![ A monetary policy that lowers interest rates and stimulates borrowing is 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 will discuss how expansionary and contractionary monetary policies affect interest
rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. We will conclude with a look at the Fed’s monetary policy practice in recent
decades.
The Effect of Monetary Policy on Interest Rates
Consider the market for loanable bank funds in [link]. The original equilibrium (E0) occurs at an 8% interest rate and a quantity of funds loaned and borrowed of $10 billion. An expansionary monetary
policy will shift the supply of loanable funds to the right from the original supply curve (S0) to S1, leading to an equilibrium (E1) with a lower 6% interest rate and a quantity $14 billion in loaned funds.
Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to S2, leading to an equilibrium (E2) with a higher 10% interest rate and
a quantity of $8 billion in loaned funds.
Monetary Policy and Interest Rates. The original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to
the new supply curve (S1) 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 curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%.
How does a central bank “raise” interest rates? When describing the central bank’s monetary policy actions, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.”
We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a
result, [link] shows that interest rates change. If they do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do.
Recall 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 operations.
Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time. In general, when
the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds
rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary
policy can push the entire spectrum of interest rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.
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 demand. Tight or contractionary monetary policy that leads to
higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money,
and even firms that have money will notice that, with higher interest rates, it is relatively more attractive 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 increase business investment and consumer borrowing for big-ticket items.
If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. [link] (a) illustrates
this situation. This example uses a short-run upward-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 will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD0) to shift right to AD1, so that the new
equilibrium (E1) occurs at the potential GDP level of 700.
Expansionary or Contractionary Monetary Policy. (a) The economy is originally in a recession with the equilibrium output and price shown at E0. Expansionary monetary policy will reduce interest
rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium (E1) at the potential GDP level of output with a relatively small rise 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
aggregate demand to the left from AD0 to AD1, thus leading to a new equilibrium (E1) at the potential GDP level of output.
Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In [link] (b), the
original equilibrium (E0) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption
spending, and cause the original demand curve (AD0) to shift left to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700.
These examples suggest that monetary policy should be countercyclical; that is, it should act to counterbalance the business cycles of economic downturns and upswings. The Fed should loosen
monetary policy when a recession has caused unemployment to increase and tighten it when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary
policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push
aggregate demand so far to the left that a recession begins. [link] (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level.
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 demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary
monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and
shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP.
Federal Reserve Actions Over Last Four Decades
For the period from the mid-1970s up through the end of 2007, we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market
operations.](https://image.slidesharecdn.com/monetisation-211220150618/95/Monetisation-by-bhawna-bhardwaj-15-638.jpg)
![ Of course, telling the story of the U.S. economy since 1975 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic
growth, and inflation over this time. The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors
influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U.S. economy is probably the Federal Reserve chairperson.
[link] 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 rate (remember, this
interest rate is set through open market operations), the unemployment rate, and the inflation rate since 1975. Different episodes of monetary policy during this period are indicated in the figure.
Monetary Policy, Unemployment, and Inflation. Through the episodes here, 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 interest rate.
Episode 1
Consider Episode 1 in the late 1970s. The rate of inflation was very high, exceeding 10% in 1979 and 1980, so the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds
rate rising from 5.5% in 1977 to 16.4% in 1981. By 1983, inflation was down to 3.2%, but aggregate demand contracted sharply enough that back-to-back recessions occurred in 1980 and in 1981–1982, and
the unemployment rate rose from 5.8% in 1979 to 9.7% in 1982.
Episode 2
In Episode 2, when economists persuaded the Federal Reserve in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest
rate fell from 16.4% in 1981 to 6.8% in 1986. By 1986 or so, inflation had fallen to about 2% and the unemployment rate had come down to 7%, and was still falling.
Episode 3
However, in Episode 3 in the late 1980s, inflation appeared to be creeping up again, rising from 2% in 1986 up toward 5% by 1989. In response, the Federal Reserve used contractionary monetary policy
to raise the federal funds rates from 6.6% in 1987 to 9.2% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but it also helped to cause the
1990-1991 recession, and the unemployment rate rose from 5.3% in 1989 to 7.5% by 1992.
Episode 4
In Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to
3.5% in 1992. As the economy expanded, the unemployment rate declined from 7.5% in 1992 to less than 5% by 1997.
Episodes 5 and 6
In Episodes 5 and 6, the Federal Reserve perceived a risk of inflation and raised the federal funds rate from 3% to 5.8% from 1993 to 1995. Inflation did not rise, and the period of economic growth during
the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4.6% in December 1998 to 6.5% in June 2000.
By early 2001, inflation was declining again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0% to 5.8%.
Episodes 7 and 8
In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2% in 2000 to just 1.7% in 2002, and then again to 1% in 2003. They actually did this
because 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 rate declined and the Federal Reserve began to raise the federal funds rate until it reached 5% by 2007.
Episode 9
In Episode 9, as the Great Recession took hold 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 down to near-zero by December 2008, the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The Federal Reserve had to think “outside
the box.”
Quantitative Easing
The most powerful and commonly used of the three 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 near-zero. With the recession still ongoing, the Fed decided to adopt
an innovative and nontraditional policy known as quantitative easing (QE). This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit
available so as to stimulate aggregate demand.
Quantitative easing differed from traditional monetary policy in several key ways. 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 economy any further by lowering short term rates because they were already as low as they could get. (Read the closing Bring it Home feature for more on
this.) Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing.
This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it
had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed “toxic assets,” because when the housing market collapsed, no one knew
what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both
pushing long term interest rates down and also removing possibly “toxic assets” from the balance sheets of private financial firms, which would strengthen the financial system.
Quantitative easing (QE) occurred in three episodes:
During QE1, which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.
In November 2010, the Fed began QE2, in which it purchased $600 billion in U.S. Treasury bonds.
QE3, began in September 2012 when the Fed commenced purchasing $40 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 economic conditions permit, it will begin tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final $15 billion bond purchase,
ending Quantitative Easing.
](https://image.slidesharecdn.com/monetisation-211220150618/95/Monetisation-by-bhawna-bhardwaj-16-638.jpg)
![ A monetary policy that lowers interest rates and stimulates borrowing is 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 will discuss how expansionary and contractionary monetary policies affect interest
rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. We will conclude with a look at the Fed’s monetary policy practice in recent
decades.
The Effect of Monetary Policy on Interest Rates
Consider the market for loanable bank funds in [link]. The original equilibrium (E0) occurs at an 8% interest rate and a quantity of funds loaned and borrowed of $10 billion. An expansionary monetary
policy will shift the supply of loanable funds to the right from the original supply curve (S0) to S1, leading to an equilibrium (E1) with a lower 6% interest rate and a quantity $14 billion in loaned funds.
Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to S2, leading to an equilibrium (E2) with a higher 10% interest rate and
a quantity of $8 billion in loaned funds.
Monetary Policy and Interest Rates. The original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to
the new supply curve (S1) 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 curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%.
How does a central bank “raise” interest rates? When describing the central bank’s monetary policy actions, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.”
We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a
result, [link] shows that interest rates change. If they do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do.
Recall 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 operations.
Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time. In general, when
the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds
rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary
policy can push the entire spectrum of interest rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.
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 demand. Tight or contractionary monetary policy that leads to
higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money,
and even firms that have money will notice that, with higher interest rates, it is relatively more attractive 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 increase business investment and consumer borrowing for big-ticket items.
If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. [link] (a) illustrates
this situation. This example uses a short-run upward-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 will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD0) to shift right to AD1, so that the new
equilibrium (E1) occurs at the potential GDP level of 700.
Expansionary or Contractionary Monetary Policy. (a) The economy is originally in a recession with the equilibrium output and price shown at E0. Expansionary monetary policy will reduce interest
rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium (E1) at the potential GDP level of output with a relatively small rise 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
aggregate demand to the left from AD0 to AD1, thus leading to a new equilibrium (E1) at the potential GDP level of output.
Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In [link] (b), the
original equilibrium (E0) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption
spending, and cause the original demand curve (AD0) to shift left to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700.
These examples suggest that monetary policy should be countercyclical; that is, it should act to counterbalance the business cycles of economic downturns and upswings. The Fed should loosen
monetary policy when a recession has caused unemployment to increase and tighten it when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary
policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push
aggregate demand so far to the left that a recession begins. [link] (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level.
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 demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary
monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and
shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP.
Federal Reserve Actions Over Last Four Decades
For the period from the mid-1970s up through the end of 2007, we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market
operations.](https://image.slidesharecdn.com/monetisation-211220150618/95/Monetisation-by-bhawna-bhardwaj-17-638.jpg)
![ Of course, telling the story of the U.S. economy since 1975 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic
growth, and inflation over this time. The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors
influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U.S. economy is probably the Federal Reserve chairperson.
[link] 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 rate (remember, this
interest rate is set through open market operations), the unemployment rate, and the inflation rate since 1975. Different episodes of monetary policy during this period are indicated in the figure.
Monetary Policy, Unemployment, and Inflation. Through the episodes here, 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 interest rate.
Episode 1
Consider Episode 1 in the late 1970s. The rate of inflation was very high, exceeding 10% in 1979 and 1980, so the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds
rate rising from 5.5% in 1977 to 16.4% in 1981. By 1983, inflation was down to 3.2%, but aggregate demand contracted sharply enough that back-to-back recessions occurred in 1980 and in 1981–1982, and
the unemployment rate rose from 5.8% in 1979 to 9.7% in 1982.
Episode 2
In Episode 2, when economists persuaded the Federal Reserve in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest
rate fell from 16.4% in 1981 to 6.8% in 1986. By 1986 or so, inflation had fallen to about 2% and the unemployment rate had come down to 7%, and was still falling.
Episode 3
However, in Episode 3 in the late 1980s, inflation appeared to be creeping up again, rising from 2% in 1986 up toward 5% by 1989. In response, the Federal Reserve used contractionary monetary policy
to raise the federal funds rates from 6.6% in 1987 to 9.2% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but it also helped to cause the
1990-1991 recession, and the unemployment rate rose from 5.3% in 1989 to 7.5% by 1992.
Episode 4
In Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to
3.5% in 1992. As the economy expanded, the unemployment rate declined from 7.5% in 1992 to less than 5% by 1997.
Episodes 5 and 6
In Episodes 5 and 6, the Federal Reserve perceived a risk of inflation and raised the federal funds rate from 3% to 5.8% from 1993 to 1995. Inflation did not rise, and the period of economic growth during
the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4.6% in December 1998 to 6.5% in June 2000.
By early 2001, inflation was declining again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0% to 5.8%.
Episodes 7 and 8
In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2% in 2000 to just 1.7% in 2002, and then again to 1% in 2003. They actually did this
because 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 rate declined and the Federal Reserve began to raise the federal funds rate until it reached 5% by 2007.
Episode 9
In Episode 9, as the Great Recession took hold 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 down to near-zero by December 2008, the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The Federal Reserve had to think “outside
the box.”
Quantitative Easing
The most powerful and commonly used of the three 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 near-zero. With the recession still ongoing, the Fed decided to adopt
an innovative and nontraditional policy known as quantitative easing (QE). This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit
available so as to stimulate aggregate demand.
Quantitative easing differed from traditional monetary policy in several key ways. 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 economy any further by lowering short term rates because they were already as low as they could get. (Read the closing Bring it Home feature for more on
this.) Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing.
This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it
had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed “toxic assets,” because when the housing market collapsed, no one knew
what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both
pushing long term interest rates down and also removing possibly “toxic assets” from the balance sheets of private financial firms, which would strengthen the financial system.
Quantitative easing (QE) occurred in three episodes:
During QE1, which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.
In November 2010, the Fed began QE2, in which it purchased $600 billion in U.S. Treasury bonds.
QE3, began in September 2012 when the Fed commenced purchasing $40 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 economic conditions permit, it will begin tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final $15 billion bond purchase,
ending Quantitative Easing.
We usually think of the quantitative easing policies that the Federal Reserve adopted (as did other central banks around the world) as temporary emergency measures. If these steps are to be temporary,
then the Federal Reserve will need to stop making these additional loans and sell off the financial 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, but that QE2 and QE3 have been less so.](https://image.slidesharecdn.com/monetisation-211220150618/95/Monetisation-by-bhawna-bhardwaj-18-638.jpg)
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Monetisation by bhawna bhardwaj
- 1. "Monetize" refers tothe process of turning a non-revenue-generating item into cash. In many cases, monetization looks to novel methods of creating income from new sources, such as embedding ad revenues inside of social media video clips to pay content creators. Sometimes, monetization is due to privatization (called commodification), whereby a previously free or public asset is turned into a profit center—such as a public road being converted into a private tollway. The term "monetize" may also refer to liquidating an asset or object for cash. . Understanding Monetization The term "monetize" can take on different meanings depending on the context. Governments monetize debt to keep interest rates on borrowed money low. Though, if the need should arise, they may also do so to avoid a financial crisis while businesses monetize products and services to generate profit. Monetization seems to go hand-in-hand with contemporary capitalism. The process of monetizing is very important to a business or other entity's growth as it is key to its strategic planning. Indeed, finding novel ways to turn otherwise neutral or costly business operations into profit centers is a goal of today's entrepreneurs and is sought after by investors.
- 2. Monetary policy. Itis a statutory and institutionalized framework under the RBI Act, 1934, for maintaining price stability, while keeping in mind the objective of growth. It determines the policy interest rate (repo rate) required to achieve the inflation target of 4% with a leeway of 2% points on either side.
- 3. What roledoes the Monetary Policy Committee play? The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016, to provide for a statutory and institutionalized framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth. The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level. The Government of India, in consultation with RBI, notified the ‘Inflation Target’ in the Gazette of India dated 5 August 2016 for the period beginning from the date of publication of the notification and ending on March 31, 2021, as 4%. At the same time, lower and upper tolerance levels were notified to be 2% and 6% respectively.
- 4. What arethe instruments of monetary policy? Some of the following instruments are used by RBI as a part of their monetary policies. Open Market Operations: An open market operation is an instrument which involves buying/selling of securities like government bond from or to the public and banks. The RBI sells government securities to control the flow of credit and buys government securities to increase credit flow. Cash Reserve Ratio (CRR): Cash Reserve Ratio is a specified amount of bank deposits which banks are required to keep with the RBI in the form of reserves or balances. The higher the CRR with the RBI, the lower will be the liquidity in the system and vice versa. The CRR was reduced from 15% in 1990 to 5 % in 2002. As of 31st December 2019, the CRR is at 4%. Statutory Liquidity Ratio (SLR): All financial institutions have to maintain a certain quantity of liquid assets with themselves at any point in time of their total time and demand liabilities. This is known as the Statutory Liquidity Ratio. The assets are kept in non-cash forms such as precious metals, bonds, etc. As of December 2019, SLR stands at 18.25%. Bank Rate Policy: Also known as the discount rate, bank rates are interest charged by the RBI for providing funds and loans to the banking system. An increase in bank rate increases the cost of borrowing by commercial banks which results in the reduction in credit volume to the banks and hence the supply of money declines. An increase in the bank rate is the symbol of the tightening of the RBI monetary policy. As of 31 December 2019, the bank rate is 5.40%. Credit Ceiling: With this instrument, RBI issues prior information or direction that loans to the commercial bank will be given up to a certain limit. In this case, a commercial bank will be tight in advancing loans to the public. They will allocate loans to limited sectors. A few examples of credit ceiling are agriculture sector advances and priority sector lending.
- 6. The Reserve Bankof India (RBI) has released the Monetary Policy Report (MPR) for the month of August 2021. It kept the policy rate unchanged for the seventh time in a row. And appealed to the centre and states to reduce taxes on fuels to curb inflationary pressures. Monetary Policy Report The MPR is published by the Monetary Policy Committee (MPC) of RBI. The MPC is a statutory and institutionalized framework under the RBI Act, 1934, for maintaining price stability, while keeping in mind the objective of growth. The MPC determines the policy interest rate (repo rate) required to achieve the inflation target of 4% with a leeway of 2% points on either side. The Governor of RBI is ex-officio Chairman of the MPC. Key Points Unchanged Policy Rates: Repo Rate - 4%. Reverse Repo Rate - 3.35%. Marginal Standing Facility (MSF) - 4.25%. Bank Rate- 4.25%. GDP Projection: Real Gross Domestic Product (GDP) growth for 2021-22 has been retained at 9.5%. Inflation:.
- 7. Optimism ForRecovery: Resilient Demand: After the second wave of infections, domestic economic activity had started to recover with accelerated vaccination. Economic Package: Although investment demand is still anaemic, improving capacity utilisation, rising steel consumption, higher imports of capital goods, congenial monetary and financial conditions and the economic packages announced by the central government are expected to kick-start a long-awaited revival. High Frequency Indicators: High-frequency indicators (electricity consumption, nighttime lights intensity and nitrogen dioxide emissions) suggest that consumption (both private and Government), investment and external demand are all on the path of regaining traction. Concerns: Inflation management can pose a serious challenge when the elevated fuel price pass through starts to occur and thus inflation shock is unlikely to be transitory even by definition. Suggestions: Reduce Taxes: With crude oil prices at elevated levels, a calibrated reduction of the indirect tax component of pump prices by the centre and states can help to substantially lessen cost pressures. Economic Stimulus: On the economic front, despite the uptick, it is important that a stimulus is provided by the government to give a thrust to consumption. The timing of such measures will be apt at this juncture as the festive season is about to begin. Policy Use: The nascent and hesitant recovery in the economy needs to be nurtured through fiscal, monetary and sectoral policy levers.
- 8. Key Terms Repo and Reverse Repo Rate: Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds. Here, the central bank purchases the security. Reverse repo rate is the rate at which the RBI borrows money from commercial banks within the country. Bank Rate: It is the rate charged by the RBI for lending funds to commercial banks. Marginal Standing Facility (MSF): MSF is a window for scheduled banks to borrow overnight from the RBI in an emergency situation when interbank liquidity dries up completely. Under interbank lending, banks lend funds to one another for a specified term. Inflation: Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc. Inflation measures the average price change in a basket of commodities and services over time. Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency. This could ultimately lead to a deceleration in economic growth. Consumer Price Index: It measures price changes from the perspective of a retail buyer. It is released by the National Statistical Office (NSO). The CPI calculates the difference in the price of commodities and services such as food, medical care, education, electronics etc, which Indian consumers buy for use.
- 9. RBI hasrevised the projection for Consumer Price Index (CPI) inflation to 5.7% from 5.1%. Variable Rate Reverse Repos: In order to absorb additional liquidity in the system, the RBI announced conducting a Variable Rate Reverse Repo (VRRR) program due to the higher yield prospects as compared to the fixed rate overnight reverse repo. The RBI has decided to increase the quantum under the VRRR to Rs 4 trillion in a phased manner. It also extended the liquidity support to banks to lend to stressed businesses by another three months to 31th December 2021. Interest Rates: Elevated inflation level and delayed recovery in the economy has prompted the panel to keep rates steady. Interest rates in the banking system are expected to remain stable in the next couple of months. Recovery faced rough weather due to the Covid second wave and lockdowns in states Accommodative Stance: It decided to continue with an accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the target going forward. An accommodative stance means a central bank will cut rates to inject money into the financial system whenever needed.
- 10. NMP is anongoing plan for “asset recycling”. Despite numerous past disappointments, the government has courageously announced a number of well-studied infrastructure programmes, which include the four-year NMP envisaging monetization of Rs 6 lakh crore worth of specified core & non-core infrastructure assets. The project envisions leasing of select government assets like roads, power lines, mines and stadiums for a specified period, after which the asset will be returned back to the government. Funds so generated will be invested in greenfield infrastructure. NMP will run parallel to National Infrastructure Pipeline (NIP) and Gati Shakti programme. This coordinated move will not only speed the infra development but also be the driving force towards creating sustainable infrastructure and ensuring the seamless movement of goods & services. In the process, employment opportunities will get generated and ease of doing business will also get facilitated. The Finance Ministry is reported to be working with other ministries, departments and state governments to quickly implement these three major reform programmes. The focus is on supply-side reforms to ease structural infrastructure bottlenecks including cost reduction instead of merely concentrating on economic normalization. Full support will come from the fact that the government has continuously been taking meaningful facilitative measures like economic stimulus packages along with timely structural reforms in various sectors that would play a pivotal role in India’s economic recovery process. GST is being reformed to achieve its potential. NaBFID- National Bank for Financing Infrastructure and Development is being set up to support long term infra financing. The government is also setting up a ‘National Land Monetization Corporation’. Government is likely to bring ‘Canada Lands Company’ on board to assist in the operations of this SPV. NMP will be implemented through relevant changes in existing contractual modes/regulatory regimes as well as capital market instruments like Infrastructure Investment Trusts (InvITs)/ Real Estate Investment Trust (REITs). These financial instruments would facilitate investors to invest in completed real estate and infrastructure assets with a low ticket size and adequate liquidity, thereby making the plan inclusive. PROS include unshackling the unproductive PSUs; boosting investors’ confidence; minimizing completion risk (roughly 50% of government assets ready for monetization); NMP’s integration with NIP and Gati Shakti would resolve the historical irritant of delay in project implementation and optimal utilization of national infrastructure. Bureaucratic silos are being done away with. States’ participation is being ensured. NMP is not about generating revenues, but about efficient management and stewardship of public infrastructure. The government has been continuously taking facilitative measures to make the NMP a success. Finance Minister has desired multilateral development banks to intensify private sector capital mobilization for inclusive and green development. Notably, the government’s thinking marks a historic shift on how India henceforth would be conducting the business of developing infrastructure. There is even talk of initiating changes in the administrative framework at the ground level. PM visualizes the initiative to be integrative and transformational. .
- 11. CONS —Though the monetization programme holds grand promise, experiences of Land Portal initiative failure, Railway auction debacle and lacklustre performance of disinvestments all paint a dismal scenario creating doubts about whether the monetization plan would be able to attract adequate buyers. Executing NMP on such a large scale is bound to face bottlenecks. Even with the assistance of highly qualified experts, it can become difficult to evaluate which specific government-owned assets should be leased out first and what benchmarks should be short-listed for projecting cash inflows for assets, especially when many may be illiquid. Opposition parties view the programme as a daylight robbery, creating a monopoly of a select few when the USA, South Korea and China are trying to control monopolies/duopolies. Monetization policy should have been debated in Parliament. There can also arise legal challenges. It is imperative that all infrastructure initiatives get underpinned by a stable and predictable policy and regulatory framework ideally suited for a liberalized environment. Another imperative is that the government’s Institutional monitoring mechanism needs strengthening by associating professionals from Industry Associations/Chambers of Commerce & Industry with it. Trust, being basic for a flowering of a true partnership, is being repeatedly emphasized by the authorities. Mindset and thought processes need to shift to the realization that profit- making is not a zero-sum game that ignores public interest. Supportive policy measures taken to build the trust are like doing away with the retrospective provision; PLI scheme which being pro-growth and pro-investment has been received well by both domestic and foreign investors; Telecom relief measures are being received well and timely Public-Private Partnership breaching the space frontier at an opportune time when several Indian and international companies have bet on satellite communications as the next frontier to provide internet connectivity at the retail level; Forest Act is being amended to ease land availability for the private sector for use of non-forestry purposes. After Air India privatization, the government hopes to close BPCL stake sale and LIC IPO by March 2022. Contractual frameworks need to consider the state as a partner and not sovereign. This will also require the government to tread cautiously on separating its regulatory role from the asset-owning one. Gati Shakti by bringing together various ministries with a view to remove the bottlenecks in project implementation would be an enabler towards making multiplier factors in the vast infrastructure sector work effectively. Besides, the issue of user charges is bound to come up. Care has to be taken that user charges are kept rational. The monetization programme is undoubtedly ambitious but not new. Success cases of monetization in India have been quite a few but these were carried out on a smaller scale like franchising of the Electricity sector in Bhiwandi, which resulted in a reduction in losses from 70% to 30%. Monetization was also successful in the case of the construction of the Mumbai Pune Highway. Asset monetization has been widely successful abroad. What is required is a different constructive mindset amongst all stakeholders along with greater clarity on the actual terms of the deals. If basic issues especially pertaining to the valuation of individual assets get sorted out, the scheme could enjoy mammoth win-win potential
- 12. Types ofMonetary Policy There are three common types of monetary policy. These are: Expansionary Monetary Policy Contractionary Monetary Policy Unconventional Monetary Policy Expansionary Monetary Policy Expansionary monetary policy is the monetary policy which seeks to increase aggregate demand and economic growth in the economy. It involves increasing the money supply and lowering the interest rates. The lower interest rate encourages the borrowers to buy more which increases the economic activity. The increased economic activity leads to more employment opportunities thus decreasing unemployment. It also increases the inflation as more money is available to buy goods and services. It is also known as Easy Money Policy or Loose Money Policy as central banks seeks to increase the money supply by lowering the interest rates. Contractionary Monetary Policy Contraction monetary policy is the monetary policy which is used to fight the inflation in economy. It involves decreasing the money supply and increasing the interest rates. As reduction in money supply increases the interest rates, the borrowers will be reluctant to borrow the money due to higher borrowing cost which ultimately reduces the economic activity. It leads to decrease in inflation, increase in unemployment and slowdown in economy. It is also known as tight money policy as central banks seeks to reduce the money supply by restricting credit by increasing interest rates. Unconventional Monetary Policy Unconventional monetary policy is pursued by central banks when their traditional instruments of monetary policy cease to achieve their goals. The one such unconventional monetary policy was employed us United States after the financial crisis of 2007 in the form Quantitative Easing (QE). Instruments of Monetary Policy in India The Reserve Bank of India employs various instruments of monetary policy in India to achieve the objectives of price stability and higher economic growth. Some of the important instrument or tools of monetary policy in India are: Open Market Operations (OMO) Cash Reserve Ration (CRR) Statutory Liquidity Ratio (SLR) Liquidity Adjustment Facility (LAF) Selective Credit Control Moral Suasion Open Market Operations (OMO) It is the process of buying and selling of government securities, bond or Treasury Bills (T-Bills) to regulate the money supply in economy. If government wants to reduce money supply, it issues these bonds. The money is consumed to buy these bonds thus it reduced the monetary base of the economy. Similarly to increase the money supply, the government sells these bonds thereby increasing the monetary base of the economy. In India, the open market operations are conducted by Reserve Bank of India through its core banking solution e-Kuber. Cash Reserve Ratio (CRR) It refers to the cash which banks have to maintain with the Reserve Bank of India as percentage of Net Demand and Time Liabilities (NDTL). An increase in CRR makes it mandatory for banks to hold large portion of their deposits with the RBI. Therefore it reduces their deposit available for credit and they lend less which affect their profitability and also reduces the money supply in economy. Statutory Liquidity Ratio (SLR) Apart from CRR, the banks in India are required to maintain liquid assets in the form of gold, cash and approved securities. The increase/decrease in SLR affects the availability of money for credit with banks. Liquidity Adjustment Facility (LAF) Under Liquidity Adjustment Facility (LAF) the banks purchase money from RBI on repurchase agreements.
- 13. Repo Rate:It is the interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF) Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF Marginal Standing Facility Under SF, the scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system Bank Rate It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. Selective Credit Control Under this method, the central influence the credit growth in country through following techniques: Specifying the margin requirements and differential rate of interests Regulating the credit for consumer durables Moral Suasion The central persuades the commercial banks to regulate the credit growth through oral and verbal communication. Why monetary policy is ineffective in India? There are many reasons for monetary policy not able to achieve its intended objectives. Some of the reasons are:
- 14. Higher proportionof Non-Bank Credit The credit market in India is largely occupied by non-bank credit providing institutions like money lenders, cooperatives, relatives, friends etc. This large segment is not affected by monetary policy instrument. Introduction of new financial instruments Mutual Fund, Venture Capital, IPO etc. have influence on overall liquidity in the economy. The monetary policy intervention by Reserve Bank of India is insignificant in these segments of financial system. High currency-deposit ratio The rural economy in India has more inclination towards the usage of cash. Thus there is high currency-deposit ratio. The monetary policy only touches the deposit section. Thus any intervention by way of monetary policy has meager effect on economy. Monetary Policy Transmission Mechanism It is the process by which monetary policy interventions get transmitted to achieve the ultimate objectives like inflation or economic growth. Monetary Policy Committee The Monetary Policy Committee (MPC) has been constituted by central government in September 2016 for maintaining price stability, while keeping in mind the objective of growth
- 15. A monetarypolicy that lowers interest rates and stimulates borrowing is 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 will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. We will conclude with a look at the Fed’s monetary policy practice in recent decades. The Effect of Monetary Policy on Interest Rates Consider the market for loanable bank funds in [link]. The original equilibrium (E0) occurs at an 8% interest rate and a quantity of funds loaned and borrowed of $10 billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to S1, leading to an equilibrium (E1) with a lower 6% interest rate and a quantity $14 billion in loaned funds. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to S2, leading to an equilibrium (E2) with a higher 10% interest rate and a quantity of $8 billion in loaned funds. Monetary Policy and Interest Rates. The original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to the new supply curve (S1) 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 curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%. How does a central bank “raise” interest rates? When describing the central bank’s monetary policy actions, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.” We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, [link] shows that interest rates change. If they do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do. Recall 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 operations. Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates. 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 demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive 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 increase business investment and consumer borrowing for big-ticket items. If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. [link] (a) illustrates this situation. This example uses a short-run upward-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 will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD0) to shift right to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700. Expansionary or Contractionary Monetary Policy. (a) The economy is originally in a recession with the equilibrium output and price shown at E0. Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium (E1) at the potential GDP level of output with a relatively small rise 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 aggregate demand to the left from AD0 to AD1, thus leading to a new equilibrium (E1) at the potential GDP level of output. Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In [link] (b), the original equilibrium (E0) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD0) to shift left to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700. These examples suggest that monetary policy should be countercyclical; that is, it should act to counterbalance the business cycles of economic downturns and upswings. The Fed should loosen monetary policy when a recession has caused unemployment to increase and tighten it when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. [link] (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level. 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 demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP. Federal Reserve Actions Over Last Four Decades For the period from the mid-1970s up through the end of 2007, we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations.
- 16. Of course,telling the story of the U.S. economy since 1975 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and inflation over this time. The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U.S. economy is probably the Federal Reserve chairperson. [link] 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 rate (remember, this interest rate is set through open market operations), the unemployment rate, and the inflation rate since 1975. Different episodes of monetary policy during this period are indicated in the figure. Monetary Policy, Unemployment, and Inflation. Through the episodes here, 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 interest rate. Episode 1 Consider Episode 1 in the late 1970s. The rate of inflation was very high, exceeding 10% in 1979 and 1980, so the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds rate rising from 5.5% in 1977 to 16.4% in 1981. By 1983, inflation was down to 3.2%, but aggregate demand contracted sharply enough that back-to-back recessions occurred in 1980 and in 1981–1982, and the unemployment rate rose from 5.8% in 1979 to 9.7% in 1982. Episode 2 In Episode 2, when economists persuaded the Federal Reserve in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest rate fell from 16.4% in 1981 to 6.8% in 1986. By 1986 or so, inflation had fallen to about 2% and the unemployment rate had come down to 7%, and was still falling. Episode 3 However, in Episode 3 in the late 1980s, inflation appeared to be creeping up again, rising from 2% in 1986 up toward 5% by 1989. In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6.6% in 1987 to 9.2% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but it also helped to cause the 1990-1991 recession, and the unemployment rate rose from 5.3% in 1989 to 7.5% by 1992. Episode 4 In Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to 3.5% in 1992. As the economy expanded, the unemployment rate declined from 7.5% in 1992 to less than 5% by 1997. Episodes 5 and 6 In Episodes 5 and 6, the Federal Reserve perceived a risk of inflation and raised the federal funds rate from 3% to 5.8% from 1993 to 1995. Inflation did not rise, and the period of economic growth during the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4.6% in December 1998 to 6.5% in June 2000. By early 2001, inflation was declining again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0% to 5.8%. Episodes 7 and 8 In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2% in 2000 to just 1.7% in 2002, and then again to 1% in 2003. They actually did this because 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 rate declined and the Federal Reserve began to raise the federal funds rate until it reached 5% by 2007. Episode 9 In Episode 9, as the Great Recession took hold 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 down to near-zero by December 2008, the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The Federal Reserve had to think “outside the box.” Quantitative Easing The most powerful and commonly used of the three 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 near-zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing (QE). This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand. Quantitative easing differed from traditional monetary policy in several key ways. 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 economy any further by lowering short term rates because they were already as low as they could get. (Read the closing Bring it Home feature for more on this.) Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing. This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed “toxic assets,” because when the housing market collapsed, no one knew what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both pushing long term interest rates down and also removing possibly “toxic assets” from the balance sheets of private financial firms, which would strengthen the financial system. Quantitative easing (QE) occurred in three episodes: During QE1, which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac. In November 2010, the Fed began QE2, in which it purchased $600 billion in U.S. Treasury bonds. QE3, began in September 2012 when the Fed commenced purchasing $40 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 economic conditions permit, it will begin tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final $15 billion bond purchase, ending Quantitative Easing.
- 17. A monetarypolicy that lowers interest rates and stimulates borrowing is 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 will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. We will conclude with a look at the Fed’s monetary policy practice in recent decades. The Effect of Monetary Policy on Interest Rates Consider the market for loanable bank funds in [link]. The original equilibrium (E0) occurs at an 8% interest rate and a quantity of funds loaned and borrowed of $10 billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to S1, leading to an equilibrium (E1) with a lower 6% interest rate and a quantity $14 billion in loaned funds. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to S2, leading to an equilibrium (E2) with a higher 10% interest rate and a quantity of $8 billion in loaned funds. Monetary Policy and Interest Rates. The original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to the new supply curve (S1) 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 curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%. How does a central bank “raise” interest rates? When describing the central bank’s monetary policy actions, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.” We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, [link] shows that interest rates change. If they do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do. Recall 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 operations. Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates. 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 demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive 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 increase business investment and consumer borrowing for big-ticket items. If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. [link] (a) illustrates this situation. This example uses a short-run upward-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 will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD0) to shift right to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700. Expansionary or Contractionary Monetary Policy. (a) The economy is originally in a recession with the equilibrium output and price shown at E0. Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium (E1) at the potential GDP level of output with a relatively small rise 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 aggregate demand to the left from AD0 to AD1, thus leading to a new equilibrium (E1) at the potential GDP level of output. Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In [link] (b), the original equilibrium (E0) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD0) to shift left to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700. These examples suggest that monetary policy should be countercyclical; that is, it should act to counterbalance the business cycles of economic downturns and upswings. The Fed should loosen monetary policy when a recession has caused unemployment to increase and tighten it when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. [link] (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level. 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 demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP. Federal Reserve Actions Over Last Four Decades For the period from the mid-1970s up through the end of 2007, we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations.
- 18. Of course,telling the story of the U.S. economy since 1975 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and inflation over this time. The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U.S. economy is probably the Federal Reserve chairperson. [link] 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 rate (remember, this interest rate is set through open market operations), the unemployment rate, and the inflation rate since 1975. Different episodes of monetary policy during this period are indicated in the figure. Monetary Policy, Unemployment, and Inflation. Through the episodes here, 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 interest rate. Episode 1 Consider Episode 1 in the late 1970s. The rate of inflation was very high, exceeding 10% in 1979 and 1980, so the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds rate rising from 5.5% in 1977 to 16.4% in 1981. By 1983, inflation was down to 3.2%, but aggregate demand contracted sharply enough that back-to-back recessions occurred in 1980 and in 1981–1982, and the unemployment rate rose from 5.8% in 1979 to 9.7% in 1982. Episode 2 In Episode 2, when economists persuaded the Federal Reserve in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest rate fell from 16.4% in 1981 to 6.8% in 1986. By 1986 or so, inflation had fallen to about 2% and the unemployment rate had come down to 7%, and was still falling. Episode 3 However, in Episode 3 in the late 1980s, inflation appeared to be creeping up again, rising from 2% in 1986 up toward 5% by 1989. In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6.6% in 1987 to 9.2% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but it also helped to cause the 1990-1991 recession, and the unemployment rate rose from 5.3% in 1989 to 7.5% by 1992. Episode 4 In Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to 3.5% in 1992. As the economy expanded, the unemployment rate declined from 7.5% in 1992 to less than 5% by 1997. Episodes 5 and 6 In Episodes 5 and 6, the Federal Reserve perceived a risk of inflation and raised the federal funds rate from 3% to 5.8% from 1993 to 1995. Inflation did not rise, and the period of economic growth during the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4.6% in December 1998 to 6.5% in June 2000. By early 2001, inflation was declining again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0% to 5.8%. Episodes 7 and 8 In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2% in 2000 to just 1.7% in 2002, and then again to 1% in 2003. They actually did this because 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 rate declined and the Federal Reserve began to raise the federal funds rate until it reached 5% by 2007. Episode 9 In Episode 9, as the Great Recession took hold 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 down to near-zero by December 2008, the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The Federal Reserve had to think “outside the box.” Quantitative Easing The most powerful and commonly used of the three 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 near-zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing (QE). This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand. Quantitative easing differed from traditional monetary policy in several key ways. 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 economy any further by lowering short term rates because they were already as low as they could get. (Read the closing Bring it Home feature for more on this.) Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing. This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed “toxic assets,” because when the housing market collapsed, no one knew what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both pushing long term interest rates down and also removing possibly “toxic assets” from the balance sheets of private financial firms, which would strengthen the financial system. Quantitative easing (QE) occurred in three episodes: During QE1, which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac. In November 2010, the Fed began QE2, in which it purchased $600 billion in U.S. Treasury bonds. QE3, began in September 2012 when the Fed commenced purchasing $40 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 economic conditions permit, it will begin tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final $15 billion bond purchase, ending Quantitative Easing. We usually think of the quantitative easing policies that the Federal Reserve adopted (as did other central banks around the world) as temporary emergency measures. If these steps are to be temporary, then the Federal Reserve will need to stop making these additional loans and sell off the financial 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, but that QE2 and QE3 have been less so.
- 19. How DoesMonetary Policy Work? In economics, both monetary and fiscal policies fall under the definition of critical mechanisms with which an economy flourishes and survives adversities. The fiscal policy influences government spending and revenue. Conversely, the monetary policy focuses on the money supply to enhance employment, GDP, price stability, national demand, etc. The underlying idea is that if there is inflation or excessive price rise, reducing the amount of money available to the consumers will decrease their purchasing power. With less money, people will buy less, reducing demand and consequently the overall price. To attain this, various measures are employed, such as changing the interest rates, reserve requirements of the banks, open market transactions, etc. For example, Paul A Volcker, the 1979 US’s central bank’s chairman, ended a painfully prolonged inflation with aggressive interest hikes. It put the economy under recessions, with millions losing jobs and consumption falling to record lows. But Volcker pulled the economy out of the inflation, which laid a strong foundation for a stable economic future. It also paved the way for separating such policies from political inference. Most central banks, such as the US’s Federal Reserve (Fed), India’s RBI, European Central Bank (ECB), etc., are responsible for monetary policies. A country’s central bank prepares and implements the policy as per the economic requirements. The Fed, for example, aims to maintain price stability and boost employment. The central bank usually takes the help of a committee in formulating and implementing monetary policy. Types of Monetary policy The types are discussed below : You are free to use this image on your website, templates etc, Please provide us with an attribution link Contractionary Policy: The central bank adopts contractionary monetary policies to control the economic conditions like inflation by shrinking the money supply in the financial system. For this purpose, the central bank sells off short-term government securities, hikes borrowing rates or increases banks’ reserve requirements. Expansionary Policy: In situations of economic slowdown, the central bank implements various expansionary policies like buying short-term government securities, lowering borrowing rates and decreasing the banks’ reserve requirements. The purpose is to uplift the money supply in the economy for enhancing consumer spending and decreasing unemployment. However, it may result in inflation. Monetary Policy Tools The central bank’s policy reforms majorly deal with economic recession and expansion. The prominent tools used for this purpose involves: Open Market Operations: The central bank purchases short-term government assets such as the US Treasury bonds or Federal assets in the open market operations. If the central bank is targeting recession, it will purchase the securities from a bank offering them. This will increase the bank’s cash flow and reserve. Doing this at the macro level will increase the money supply in the country. In contrast, when it plans to reduce the cash flow, it sells the securities, reducing the reserves and availability of cash. Reserve Requirement: Changes in the central bank’s prescribed limit of reserves that the commercial banks need to maintain from their customer deposits is an essential tool. In the situation of economic expansion, the reserve requirement is increased to decrease the money supply in the system. On the other hand, it is decreased as part of the expansionary policy. Discount Rate: Central bank changes an interest for short-term lending to the commercial banks, which is referred to as a discount rate. The loan helps in meeting reserve requirements and short-term cash flow. If the bank increases the discount rate, it eventually permeates to other rates, including those on commercial loans. As a result, increasing commercial loan rates will discourage people from borrowing, thereby bringing down the money supply under inflation. Real-World Examples Let’s look at some recent monetary policy examples from the real world. Amidst the coronavirus pandemic, the US Federal Reserve lowered the benchmark interest rate close to zero per cent. Although the benchmark indicates the rate of interbank short-term borrowing, it affects the overall borrowing rate, including those for consumer loans. As such, this was an example of expansionary monetary policy which was adopted to avoid a money crunch. It also focussed on bringing down unemployment numbers and economic slowdown. Another recent report talked about China’s Coronavirus stimulus program ending in advance as the economy showed an impressive recovery. The stimulus had involved lowering interest rates. FAQs What is monetary policy? How does it work?Monetary policy is the macroeconomic action taken by a country’s central bank to check the nation’s money supply and economic stability. In 1979, Paul A Volcker, the US’s central bank’s chairman, ended a painfully prolonged inflation with aggressive interest hikes. In the latter half of the 1980s, the average inflation hovered around 3.5%, record lows from double digits of troublesome years. What are the 3 main tools of monetary policy?The three tools of monetary policy are: 1. Open Market Operations – central bank buying or selling securities to expand or contract the money supply. 2. Reserve Requirement – Increasing or decreasing reserve amount requirements of the bank that are set aside to meet emergency fund requirements for consumers. 3. Discount Rate – Increasing or decreasing the interest rates the central bank charges for interbank short-term lending. Who controls monetary policy?A country’s central bank such as the US Federal Reserve (Fed), formulates, administers, and controls this policy. What are the goals of monetary policy?The primary goals of monetary policy include long-term interest rates regulation, price stability, employment generation and economic growth. Recommended Articles This has been a guide to Monetary Policy. Here we discuss its definition, Objective and types of monetary policies. You may also look at the following economics articles to learn more –