ECONOMICS TOPIC 9 LESSON 5

ECONOMICS TOPIC 9 LESSON 5

The Effects of Monetary Policy

ESSENTIAL QUESTION

What is the proper role of the government in the economy?

OBJECTIVES

•Explain how monetary policy works.

•Describe how the timing of monetary policy can impact business cycles and key economic indicators.

•Analyze the costs and benefits of monetary policy in terms of economic growth.

•Contrast two general approaches to monetary policy.

The Basics of Monetary Policy

Proper timing can support the Fed’s effort to achieve economic growth and stability. Bad timing can impede it.

How Money Supply Impacts Interest Rates

The market for money is like any other market. If the supply is higher, the price—the interest rate—is lower. If the supply is lower, the price is higher. In other words, when the money supply is high, interest rates are low. When the money supply is low, interest rates are high.

How Interest Rates Affect Spending

If the macroeconomy is experiencing a contraction—declining income—the Federal Reserve may try to stimulate, or expand, it. The Fed will follow an easy money policy. That is, it will increase the money supply. 

How Interest Rates Affect Spending

If the economy is experiencing a rapid expansion that may cause high inflation, the Fed may introduce a tight money policy. That is, it will reduce the money supply. The Fed reduces the money supply to push interest rates upward. By raising interest rates, the Fed causes investment spending to decline. 

Multiple Choice

Identify Cause and Effect What would likely happen to interest rates if the supply of money were increased?

• Interest rates would go up.

• Interest rates would stay the same.

• Interest rates would go down.

• Interest rates are not affected by money supply.

Timing Monetary Policy

Monetary policy, like fiscal policy, must be carefully timed if it is to help the macroeconomy. Properly handled, monetary policy can help the nation’s economy grow at a steady, sustainable pace. If policies are enacted at the wrong time, they could actually intensify the business cycle rather than stabilize it.

The Results of Good Timing

To see why, consider Graph A shows the business cycle with a properly timed stabilization policy. The purple curve, which shows greater fluctuations, represents a normal business cycle. The goal of stabilization policy is to smooth out those fluctuations—in other words, to make the peaks a little bit lower and the troughs not quite so deep.

The Results of Bad Timing

If stabilization policy is not timed properly, however, it can actually make the business cycle more extreme, not smoother. The orange line in Graph B it shows the result of a poorly timed monetary policy, producing higher peaks and lower valleys than might otherwise occur.

Inside Lags

The inside lag is the time it takes to implement monetary policy. Such lags, or delays, occur for two reasons. First, it takes time to identify a problem.

A second reason for inside lags is that once a problem has been recognized, it can take additional time to enact policies. 

Outside Lags

Once a new policy is determined, it takes time to become effective. This time period, known as the outside lag, also differs for monetary and fiscal policy. For fiscal policy, the outside lag lasts as long as is required for new government spending or tax policies to take effect and to begin to affect real GDP and the inflation rate. 

Multiple Choice

Apply Concepts What problem can result from expansionary monetary policy that takes effect after the economy has already begun to expand following a period of contraction?

• deflation

• inflation

• stabilization

• fluctuation

Anticipating Business Cycles

The Federal Reserve must do more than react to current trends. It must also anticipate changes in the economy. How should policymakers decide when to intervene in the economy?

How Monetary Policy Affects Inflation

An expansionary policy, if enacted at the wrong time, may push an economy into high inflation. .

An inflationary economy can be tamed by a tight money policy, but the timing is again crucial. If the policy takes effect as the economy is already cooling off on its own, the tight money could turn a mild contraction into a full-blown recession.

How Quickly Do Economies Self-Correct?

Economists disagree on the answer to this question. Their estimates for the U.S. economy range from two to six years.

Multiple Choice

Analyze Information What would be the appropriate course of action for the Fed if it predicted that a recession would quickly turn into an expansion?

• increase the money supply to lower interest rates

• decrease the money supply to raise interest rates

• lobby Congress for more federal spending

• do nothing

Debating Monetary Policy

In practice, the lags discussed here make monetary and fiscal policy difficult to apply. The lags and the general complexity of the national economy also make it difficult to sort out how different policies have affected the economy in the past. Economists have debated these matters for many years.

Debating Monetary Policy

Some economists believe that governments should emphasize fiscal policy more than monetary policy. These economists are in the tradition of John Maynard Keynes. According to them, government spending should be used to smooth out the peaks and valleys of the business cycle.

Debating Monetary Policy

Other economists are more in tune with the ideas of Milton Friedman. That is, they have greater faith in monetary policy. These proponents of monetarism believe that adjusting the money supply is the most useful tool to improve macroeconomic performance.

Debating Monetary Policy

Other economists, such as Friedrich Hayek, have taken different views. Hayek questioned economists’ ability to influence the economy effectively and had faith in a free economy’s ability to self-adjust.

Multiple Choice

Check Understanding What do monetarists believe about monetary policy?

• Monetary policy is the most useful tool to improve macroeconomic performance.

• Fiscal policy is the most useful tool to improve macroeconomic performance.

• Domestic policy is the most useful tool to improve macroeconomic performance.

• Governments should not interfere with the economy

Open Ended

What is the proper role of the government in the economy?