Monetary Policy

You’ll be able to

Identify the central bank’s tools of monetary policy
Distinguish expansionary from contractionary monetary policy
Trace the transmission from a policy tool through interest rates to aggregate demand

The tools of monetary policy

The central bank (the Federal Reserve in the U.S.) controls the money supply with three tools. Open-market operations (OMO) — buying or selling government bonds — is the primary, most-used tool: buying bonds injects reserves and increases the money supply, while selling bonds drains reserves and decreases it. The reserve requirement sets how much banks must hold; lowering it frees reserves for lending. The discount rate is the interest rate the Fed charges banks for short-term loans; lowering it encourages banks to borrow and lend more. Adjusting the interest rate paid on reserves also influences how much banks lend.

Expansionary vs. contractionary monetary policy

Expansionary (easy) monetary policy aims to fight a recession: the Fed buys bonds, lowers the reserve requirement, or lowers the discount rate to increase the money supply, which lowers interest rates, raises investment, and shifts AD right. Contractionary (tight) monetary policy fights inflation: the Fed sells bonds, raises the reserve requirement, or raises the discount rate to decrease the money supply, which raises interest rates, curbs investment, and shifts AD left. As with fiscal policy, the choice matches the gap — expansionary for recessionary gaps, contractionary for inflationary gaps.

The transmission mechanism

Monetary policy reaches the real economy through a chain: a change in the money supply changes the interest rate in the money market, the interest rate changes investment (and interest-sensitive consumption), and the change in investment shifts aggregate demand, which changes real GDP, the price level, and unemployment. For expansionary policy: money supply ↑ → interest rate ↓ → investment ↑ → AD ↑ → real GDP ↑. Every link matters — the exam expects you to state the whole chain, not just the first and last steps.

The monetary transmission chain (expansionary)

Buy bonds → MS ↑ → interest rate ↓ → investment ↑ → AD ↑ → real GDP ↑, unemployment ↓

Reverse every arrow for contractionary policy (sell bonds → MS ↓ → interest rate ↑ → investment ↓ → AD ↓).

Worked example

The economy is in a recession with a recessionary gap. Describe the appropriate open-market operation and trace its full effect through to real GDP and unemployment.

1.A recessionary gap calls for expansionary monetary policy, so the central bank buys government bonds.
2.Buying bonds increases banks’ reserves and the money supply.
3.A larger money supply lowers the equilibrium nominal interest rate in the money market.
4.Lower interest rates reduce borrowing costs, raising interest-sensitive investment (and some consumption).
5.Higher investment shifts AD right, raising real GDP and reducing cyclical unemployment (while nudging the price level up).

Answer: The central bank should buy bonds (expansionary OMO). This raises the money supply, lowers interest rates, increases investment, and shifts AD right — raising real GDP and lowering unemployment to close the recessionary gap.

Checkpoint

To fight rising inflation from an inflationary gap, which monetary policy action is appropriate?

Watch out

Get the bond direction right: the central bank buys bonds to expand the money supply and sells bonds to contract it. Reversing this — a very common slip — flips your entire prediction for interest rates, AD, and output.

Checkpoint

The central bank increases the money supply. Which sequence correctly traces the effect on the economy?

On the exam

On free-response questions, spell out every link in the transmission chain — money supply, interest rate, investment, AD, and real GDP — in the correct direction. Skipping the interest-rate or investment step usually costs a point even if your final answer is right.

Answer the 2 checkpoints as you read.