3. Objectives
• By the end of this lesson you must be able to
– Explain how the central bank can use various tools of monetary
policy to implement a tight or easy monetary policy.
– Compare effectiveness of various tools of monetary policy.
– Explain the effect of monetary policy of GDP
– Describe strengths and weaknesses of monetary policy.
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AAE 221: Agricultural Economics II
4. Two Basic Approaches
• Just as with the fiscal policy, the approach to the implementation of
the monetary policy depends on the macroeconomic problem that
has to be solved.
• The two basic approaches of monetary policy implementation are:
1. Easy Money Policy, and
2. Tight Money policy.
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6. • Easy Money policy (or expansionary monetary policy) is implemented
when the economy faces recession and unemployment.
• The purpose of Easy money policy is to increase aggregate demand,
output and employment by making bank loans less expensive and
more available.
• The reserve Bank decides to increase the supply of money in order to
increase aggregate demand so as to employ idle resources.
• To increase the money supply, the Reserve Bank must increase the
excess reserves of commercial banks.
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Easy Monetary Policy
7. Easy Monetary Policy
• This is done as follows:
– Buy securities – By purchasing securities in the open market, the
Reserve bank can increase commercial bank reserves.
– Lower the reserve ratio – By lowering the reserve ratio, the Reserve
Bank changes required reserves into excess reserves and increases
the size of the monetary multiplier.
– Lower the discount rate – By lowering the discount rate, the Reserve
Bank may entice commercial banks to borrow more reserves from
the Reserve Bank.
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AAE 221: Agricultural Economics II
9. • When excessive spending is pushing the economy into an inflationary
spiral, Tight Money Policy (or Restrictive Monetary Policy) tends to be
appropriate.
• The objective is to tighten the supply of money in order to reduce
spending and control inflation.
• The Reserve Bank should try to reduce aggregate demand by limiting or
contracting the supply of money; that means reducing the reserves of
commercial banks.
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Tight Money Policy
10. Tight Money Policy
• This is done in the following ways:
– Sell securities – By selling bonds in the open market, the Reserve
Bank can reduce commercial bank reserves.
– Increase the reserve ratio – An increase in the reserve ratio will
automatically strip commercial banks of their excess reserves and
decrease the size of the monetary supplier.
– Raise the discount rate – A boost in the discount rate will discourage
commercial banks from borrowing from the Reserve Bank in order to
build up their reserves.
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AAE 221: Agricultural Economics II
11. Relative Importance of Tools of Monetary Policy
• Of the three instruments of monetary control, buying and selling
securities in the open market is the most important in solving problems
of recession, unemployment and inflation.
• This technique has the advantage of flexibility
– Government securities can be purchased or sold in large or small
amounts.
– The impact on bank reserves is prompt (without delay).
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12. Relative Importance of Tools of Monetary Policy
• Changing the reserve requirement (reserve ratio) is a less important
instrument of monetary control.
– There is limited use of changes in reserve ratio because reserves earn
no interest.
– Consequently, raising or lowering reserve requirements has a
substantial effect on bank profits.
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AAE 221: Agricultural Economics II
13. • The Reserve Bank often lowers or raises the discount rate, but this tool is
much less important than open market operations.
• Indeed, open market operations often lead the commercial banks to borrow
from the Reserve Bank.
• That is, if the Reserve Bank sales of bonds to the public leave commercial
banks temporarily short of reserves.
• Commercial banks borrow from the Reserve Bank in response to open-
market operations rather than in response to changes in the discount rate.
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Relative Importance of Tools of Monetary Policy
14. Relative Importance of Tools of Monetary Policy
• At best, the discount rate has an “announcement effect”; it is a clear
and explicit way for the Reserve Bank to communicate to the financial
community and the general economy the intended direction of the
monetary policy.
• More likely, the discount rate is “passive.”
• The Reserve bank changes discount rates simply to keep it in line with
other short-term interest rates such as the Reserve Bank fund rates,
rather than to implement monetary policy.
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AAE 221: Agricultural Economics II
15. MONETARY POLICY, REAL GDP, AND THE PRICE
LEVEL
(THE BASIC IS-LM MODEL)
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AAE 221: Agricultural Economics II
16. Sm1 Sm2 Sm3 (i) Investment Demand
10 10
8 8
6 Dm 6
0 $125 $150 $175 0 $15 $20 $25
Amount of Money Demanded and Amount of Investment
Supplied (billions of Dollars) (billions of Dollars)
(a) (b)
Figure 7.1. Monetary policy and equilibrium GDP
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Monetary Policy and Equilibrium GDP
• An easy money policy may
shift the money supply curve
rightward from Sm1 to Sm2
and lowers the interest rate
from 10% to 8%.
• As a result, investment
spending increases from $15
billion to $20 billion. Rate
of
interest
(%)
17. Monetary Policy and Equilibrium GDP
AS
P3
AD1 (I=$15)
P2 AD3 (I=$25)
P1
AD2 (I=$20)
Real Domestic Product, GDP (Billion $)
Figure 7.1c. Monetary policy and equilibrium GDP
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• This shifts the aggregate
demand curve rightward
from AD1 to AD2 .
• Real output rises from the
recessionary level Q1 to the
full-employment level Qf.
0 Q1 Qf Q3
Price
level
18. • A tight money policy that shifts the money supply curve leftward from
Sm3 to Sm2 increases the interest rate from 6% to 8%.
• Investment spending thus falls from $25 billion to $20 billion, and the
aggregate demand curve shifts from AD3 to AD2, thereby curtailing
inflation (Figure 7.1c).
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Monetary Policy and Equilibrium GDP
19. Effect of an Easy Money Policy
• Assuming that the money supply is $125 billion (Sm1) and the resulting real
output is far below the full-employment output (Qf), then the economy
must be experiencing substantial unemployment.
• The Reserve bank therefore should institute an easy money policy.
• The intended outcome will be an increase in excess reserves in the
commercial banking system.
• Because excess reserves are the basis on which commercial banks and
thrifts can earn profit money by lending and thus creating checkable-
deposit money, the nation’s money supply probably will rise.
• An increase in the money supply will lower the interest rate, increasing
investment, aggregate demand, and equilibrium GDP.
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20. Example:
• An increase in the money supply from $125 billion to $150 billion (Sm1 to
Sm2) will reduce the interest rate from 10% to 8% (Figure 7.1a), and will
boost investment from $15 billion to $20 billion (Fig. 7.1b) - thereby
producing an increase of $5 billion in investment.
• If the economy’s MPC is 0.75, the multiplier will be 4 (= 1/MPS; =1/0.25).
• Through the multiplier effect, the $5 billion increase in investment will shift
the AD curve rightward by $20 billion (= 4 × $5 billion) at each price level.
• Specifically, aggregate demand will shift from AD1 to AD2 (Figure 7.1c).
• This rightward shift in aggregate demand will increase GDP from Q1 to Qf.
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Effect of an Easy Money Policy
21. Summaries of the working of Monetary policies on
Recession and Inflation
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(1)
Easy Money Policy
(2)
Tight Money Policy
Problem Unemployment and Recession Inflation
Approach Reserve Bank buys bonds,
lowers reserve ratio, or lowers
the discount rate
Reserve Bank sells bonds,
increases reserve ratio, or
increases the discount rate
Effect Excess reserves increase Excess reserves decrease
Money supply rises Money supply falls
Interest rate falls Interest rate rises
Investment spending increases Investment spending decreases
Aggregate demand increases Aggregate demand decreases
Impact Real GDP rise by a multiple of
the increase in investment; the
economy recovers; employment
increases.
Inflation declines
23. Strengths of Monetary Policy
• Speed and flexibility –
– Compared with fiscal policy, monetary policy can be quickly altered.
– Rather than waiting for Parliamentary approval, the Reserve Bank can
buy or sell securities from day to day and thus affect the money supply
and interest rates almost immediately.
• Isolation from political pressure –
– Because members of the Reserve Bank’s Board of Governors are
appointed and serve relatively longer, they are, to some extent, isolated
from lobbying by voters under the influence of political groupings.
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24. • Less control
– Changes in banking practices may reduce, or make less predictable, the
Reserve bank’s control of the supply of money.
• Changes in velocity
– If the money supply is $150 billion, total spending will be $600 billion if
velocity is 4 but only $450 billion if velocity is 3.
– Velocity may increase during inflation when the Reserve Bank restrains
money supply and decrease during recession
• Cyclical asymmetry
– Monetary policy may be less reliable in pushing the economy out of
recession. 24
Shortcomings of Monetary Policy
25. Conclusion
• In this lesson you have learnt that the central bank can use
tight or easy monetary policy to influence control inflation and
recession in an economy.
• You have also learnt that monetary policy is faster and more
independent from political influence than fiscal policy.
• This marks the end or the course.
• I wish you all the best as you prepare for end of semester
exams.
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AAE 221: Agricultural Economics II
