Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- Monetary policy: central bank action on interest rates and the money supply to reach goals such as price stability and full employment.
- Policy rate: the target for the overnight interbank lending rate (in the United States, the federal funds rate).
- Limited reserves: reserves are scarce; the central bank moves rates by changing the quantity of reserves (and so the money supply).
- Ample reserves: extra reserves do not move the rate; the central bank changes administered rates, mainly the interest on reserves. The United States has ample reserves.
- Open market purchase: reserves and the monetary base rise. With limited reserves, the money supply rises by more than the base because of the money multiplier.
- Lags: it takes time to recognise a problem and for the economy to adjust to the policy.
Key relationships
| Tool | Expansionary | Contractionary |
|---|---|---|
| Open market operations | Buy bonds | Sell bonds |
| Required reserve ratio | Lower | Raise |
| Discount rate | Lower | Raise |
| Interest on reserves | Lower | Raise |
Expansionary chain: policy action → interest rates fall → investment and interest-sensitive consumption rise → AD right → real output up, unemployment down, price level up.
Contractionary chain: policy action → interest rates rise → investment and consumption fall → AD left → real output down, price level down.
Calculation: maximum money multiplier = 1 ÷ required reserve ratio; maximum change in money supply = new excess reserves × money multiplier (plus any new deposit itself, if the purchase is from the public).
Mistakes to avoid
- Calling a bond purchase contractionary. Buying bonds is expansionary.
- Giving the change in the monetary base as the change in the money supply.
- Saying OMOs move the policy rate in an ample-reserve system.
- Mixing up the discount rate (central bank lends to banks) and the policy rate (banks lend to each other).
- Shifting SRAS instead of AD after a monetary policy action.
- Describing government spending or taxes as monetary policy.
Quick self-check
VD is the valda, the currency of the fictional country Valdoria used in the study guide.
- The central bank buys VD 12 bn of bonds from banks; the required reserve ratio is 25% and reserves are limited. What are the changes in the monetary base and the maximum change in the money supply? (+VD 12 bn; +VD 48 bn)
- The central bank sells VD 3 bn of bonds to banks; reserves are limited and the ratio is 10%. Maximum change in the money supply? (−VD 30 bn)
- An economy with ample reserves has high inflation. Which tool should the central bank use, and in which direction? (Raise the interest on reserves.)
Next: practice questions.