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Monetary Policy 101 #2

There are two policies that can affect monetary policy in a country. These are the Expansionary Policy and the Contractionary Policy.

A)Expansionary Policy 

In this policy main goal is about expanding the money supply and to do this central bank can do mainly three things. These are.

  • Purchasing government securities.
  • Reducing the discount rate.
  • Decreasing the reserve ratio.

All these steps are used by a central bank to strengthen the economy.

« Purchasing Government Securities: If there is a recession or high unemployment, a central bank can use the expansionary monetary policy. The process starts with the open market operations and the central bank buys government securities in the bond market. In that way, money in circulation increases, and commercial banks have more available money to lend.

 -When banks have money to lend, they decrease the interest rates to attract people

« Reducing the Discount Rate: When a central bank cut interest rates, it increases the money demand in an economy and borrowing becomes cheaper and people become less willing to save so it encourages companies to invest, individuals to spend. Also, it reduces the value of money. This makes exports cheaper thus, the demand for export increases. 

« Decreasing the Reserve Ratio: Reserve ratio is the percentage of cash money that the bank has to hold in reserves in case of sudden withdrawals. It is also used by central banks to increase or decrease the money supply. Currently, the reserve ratio is 10% in the U.S. and some other countries. 

-If the Central Bank wants to stimulate the economy, they decrease the Reserve Ratio. 

It affects the commercial banks directly because when the reserve ratios are decreased, commercial banks obtain more cash on their hand and they can lend more money and gain more interest.

B) Contractionary Policy 

If the Central Bank considers inflation as a threat, they implement generally Contractionary Monetary Policy. Their aim is to decrease the inflation by limiting the money in circulation in the economy. As in the other monetary policies, they use the same tools to control the money supply.  

  • Expand Open Market Operations
  • Increase the Short-Term Interest Rate 
  • Raise the Reserve Requirements

« Expand Open Market Operations: When the central bank wants to reduce the money in circulation, it sells large portions of securities (like government bond). Thus, commercial banks lose most of their money to lend and they start to charge a higher interest rate. 

Bond sales decrease the money supply and increase the interest rate

« Increase the Short-Term Interest Rate: Commercial banks consider the interest rates when they want to reduce the money supply. Increasing the interest rate affects consumer spending. So, the aggregate demand curve will shift to left and price levels and real output will decrease. Thus, the capital in the economic system will be decreased.

« Raise the Reserve Requirements: Reserve requirement is the minimum amount of money that banks have to keep for unexpected withdrawals. When this ratio is increased, it means that the bank will have less money to lend. So, it will also cause a reduction in the money supply.

** Central banks do not use this tool because increasing or decreasing the reserve requirement ratio changes some procedures and regulations. So, changing interest rate or open market operations are easier than this.

Long-Run Aggregate Supply (LRAS): a line that shows the relationship between price level and real GDP for all supplied prices, including nominal wages, were fully flexible; price can change along the LRAS, but output cannot change because that output reflects the full employment output.

Short-Run Aggregate Supply (SRAS): a line that shows the positive relationship between the aggregate price level and amount of aggregate output supplied in the economy.

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