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Monetary policy
 Monetary policy is the process by which
the government, central bank or monetary
authority of a country controls
 (i) the supply of money
 (ii) availability of money
 (iii) cost of money or rate of interest
in order to attain a set of objectives oriented
towards the growth and stability of the
economy
 GOALS OF MONETARY POLICY
To assist the economy in achieving a full-
employment, non inflationary level of total output
 Monetary policy is geared towards
influencing interest rates
 If government can affect interest rates,
then the government can affect consumer
and firm behavior
 expansionary policy
 expansionary policy increases the total supply of money in
the economy
 used to combat unemployment in a recession by lowering
interest rates,

contractionary policy
 contractionary policy contractionary policy decreases the
total money supply
 involves raising interest rates in order to combat inflation
 increasing interest rates slows the economy by making
funds more expensive to firms, and promotes consumer
savings which decreases revenues by firms.
 TOOLS OF MONETARY POLICY
Open-Market Operations
 Buying Securities
 From commercial banks...
 Bank gives up securities
 FED pays bank
 Banks have increased reserves
 From the public...
 Public gives up securities
 Public deposits check in bank
 Banks have increased reserves
Buying increases the money supply and
lowers rates
 Open-Market Operations

 Selling Securities
 To commercial banks...
 FED gives up securities
 Bank pays for securities
 Banks have decreased reserves
 To the public...
 FED gives up securities
 Public pays by check from bank
 Banks have decreased reserves
Selling decreases the money supply and
increases rates
 The Reserve Ratio

 Raising the Reserve Ratio

– Banks must hold more reserves
– Banks decrease lending
– Money supply decreases
 Lowering the Reserve Ratio
– Banks may hold less reserves
– Banks increase lending
– Money supply increases
 The Discount Rate

 Easy Money Policy

– Buy Securities
– Decrease Reserve Ratio
– Lower Discount Rate
 Tight Money Policy
– Sell Securities
– Increase Reserve Ratio
– Raise Discount Rate
 Cause-Effect Chain
Interest Rates and Money Supply
 Interest Rates and Money Supplying
money supply affect interest rates
1. An increase in money supply makes the economy feel
wealthier by putting more money in the hands of
consumers
2. An increase in money supply decreases interest rates
 When interest rates are attractive to
consumers and firms, they borrow & buy,
hence increasing money supply increases
economic activity
MONETARY POLICY AND EQUILIBRIUM GDP
Sm1 Sm2 Sm3
Investment

Real rate of interest, i

10 10 Demand

8 8

6 6
Dm
0 0
Quantity of money demanded and supplied Amount of investment, i

AS If the Money Supply

Increases to Stimulate
the Economy…
Interest Rate Decreases
Price level

P3 Investment Increases
P2 AD & GDP Increases
P1 AD3(I=$25) with slight inflation
AD2(I=$20) Increasing money supply
AD1(I=$15) continues the growth –
Real domestic output, GDP but, watch Price Level.
Impacts of tight money policy2007
 Excess aggregate demand pressures
in the economy reduced
 Hold in import demand
 was successful in sustaining a
downtrend in inflationary pressures
 effective
 liquidity management has allowed
adequate growth in private sector
credit