Monetary policy affects aggregate demand and the economy through the money supply. For example, an increase in the money supply increases liquidity in the economy. As a result, more credit is available, and interest rates fall. Finally, households and businesses can borrow more cheaply, prompting them to increase consumption and capital spending.
Unlike fiscal policy, monetary policy is generally under the central bank as the monetary authority. Indeed, both economic policies aim to influence the economy to achieve macroeconomic goals. However, the central bank does so through changes in the policy rate, the reserve requirement ratio, and open market operations. Meanwhile, fiscal policy works through changes in taxes and government spending.
What are the monetary policy instruments?
Monetary policy is an economic policy by the central bank to influence the money supply in the economy. To do so, the central bank has several instruments, including:
- Policy rate
- Reserve requirement ratio
- Open market operations
The policy rate sometimes referred to as the benchmark interest rate, is the short-term interest rate for commercial bank deposits or loans at the central bank. An example is the fed funds rate (FFR) in the United States. Changes in the policy rate affect the interest rates commercial banks charge their customers on loans and deposits.
Meanwhile, the reserve requirement ratio refers to the portion of deposits the commercial banks must set aside as reserves. Let’s say the ratio is 5%. Commercial banks must hold $5 when they get $100 deposits. The rest, $95, they can lend. Thus, the lower the ratio, the more money there is available to lend.
Lastly, open market operations involve the central bank selling or buying government securities. The transaction involves a commercial bank as a partner. For example, the central bank purchases government securities held by commercial banks. In such cases, the money goes from the central bank to the commercial bank. Thus, commercial banks have more money to lend. If the transaction involves a substantial amount, we call it quantitative easing (QE).
Monetary policy affects the economy through its effects on the money supply and liquidity, transmitted to interest rates, credit, asset prices, exchange rates, and economic actors’ expectations. For example, lowering the reserve requirement ratio leaves commercial banks with more money to lend. And every $1 they lend will be multiplied through the money multiplier effect.
How does monetary policy affect aggregate demand and the economy?
The central bank has two types of monetary policy. When it is implemented depends on the objectives to be achieved. Meanwhile, which instrument to use depends on the central bank’s discretion. The two policies are:
- Expansionary monetary policy
- Contractionary monetary policy
The expansionary monetary policy seeks to expand the money supply in the economy. More money is available, resulting in increased liquidity. As a result, interest rates fall, and more credit is available.
Expansionary policies seek to increase aggregate demand, which in turn impacts economic variables such as economic growth and inflation rates. Therefore, we also refer to this policy as a loose or accommodative monetary policy.
Meanwhile, the contractionary monetary policy aims to limit the money supply growth. As a result, less money is available. As liquidity in the economy tightens, interest rates rise, and less credit is available. This situation weakens aggregate demand, ultimately slowing economic growth and inflation rates. We also refer to this policy as a tight monetary policy.
Expansionary monetary policy
Expansionary monetary policy stimulates economic growth by encouraging aggregate demand through an increase in the money supply. The central bank adopts this policy when the economy is in recession or with low growth.
To increase the money supply in the economy, the central bank can combine the following options:
- Cutting interest rates
- Buying government debt
- Lowering the reserve requirement ratio
Cutting interest rates
Commercial banks will follow suit when the central bank cuts policy rates. If they cut interest rates, borrowing becomes cheaper. Thus, households can increase consumer spending financed by loans.
Households often rely on loans to buy durable goods such as autos and household furniture. So, when more cheap loans become available, we expect them to increase demand.
Meanwhile, for businesses, lower interest rates make funding costs lower. For example, they can pay a lower coupon when issuing debt securities. As a result, it gives them more incentive to invest.
Increased household consumption and business investment boost aggregate demand. As a result, the economy’s output grew as businesses increased production to meet demand. In addition, they began to increase overtime, creating more income for the household.
If demand grows strongly, businesses increase capital spending, especially on items such as heavy machinery. They also recruited more workers to operate the new machines. These conditions ultimately create more household jobs and income, leading to a further increase in aggregate demand.
Buying government securities
When the central bank buys government securities, money changes hands from the central bank to the commercial bank as the counterparty. The money then circulates into the economy through loans. And through the money multiplier effect, every dollar lent results in a multiplier increase in the money supply.
An increase in the money supply increases liquidity in the economy. As a result, more money supply pushes interest rates down. In addition, more credit is available to lend to households and businesses.
Lowering the reserve requirement ratio
Commercial banks are generally not allowed to lend all their deposits as loans. Instead, the central bank requires them to keep some in reserve. What percentage is kept as a reserve? That is the reserve requirement ratio.
Commercial banks hold more money for each deposit received when the reserve ratio falls. So, they can use it as a loan. For example, the ratio dropped from 10% to 5%. As a result, commercial banks hold $5 for every $100 deposit received as reserves. As a result, they could lend $95 more than before ($90).
Contractionary monetary policy
The contractionary monetary policy reduces the money supply. As a result, fewer credits are available. That makes liquidity in the economy tighten, pushing interest rates up. As a result, loans become more expensive and, consequently, lower aggregate demand through their effect on household consumption and business investment.
The central bank pursues contractionary monetary policy during the boom phase, the final part of the economic expansion. In this phase, the economy faces strong inflationary pressures, overheating the economy. If not moderated, it could lead the economy into hyperinflation, which creates instability as the purchasing power of money falls in a short period.
The central bank then intervened to prevent such a bad situation from happening. They adopted a tighter monetary policy by combining the following options:
- Raising interest rates
- Selling government securities
- Raising the reserve requirement ratio
Raising policy rate
Commercial banks will follow suit when the central bank raises the policy rate. They raise interest rates on loans, making them more expensive for borrowers. Finally, the increase disincentives households and businesses to shop and invest. Instead, it encourages people to save for higher returns.
As a result, an increase in interest rates will make economic actors spend less money on consumption and investment. For example, households delay purchasing durable goods. Likewise, businesses delay investment because, combined with weak consumer spending, high-interest rates make investment less viable.
Overall, an increase in interest rates reduces aggregate demand and affects indicators such as inflation and economic growth. For example, it lowers inflationary pressure as the price level declines. However, it also has a negative effect, i.e., weaker economic growth.
Selling government securities
Central banks may choose to carry out open market operations by selling government securities when adopting tight monetary policies. As a result, money changes hands from commercial banks to central banks. As a result, commercial banks have less money to lend.
Credits are becoming more scarce. And liquidity in the economy tightened, pushing interest rates up. Consequently, aggregate demand declined due to weakening consumption and investment spending.
Raising the reserve requirement ratio
Increased reserve requirement ratio leaves commercial banks with less money to lend. This is because they set aside larger deposits as reserves.
Say the ratio goes up from 5% to 10%. As a result, commercial banks can only lend $90 for every $100 deposit received, lower than before ($95).
This situation reduces the credit availability in the economy. In addition, interest rates rise as liquidity tightens.
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