Money, Banking, and Monetary Policy ❮ 151
This process works in reverse if, instead of an initial deposit, Katie makes a $1,000
withdrawal and puts the cash under her mattress. Rather than money creation, this could
be called money destruction.
11.3 Monetary Policy
Main Topics: Expansionary Monetary Policy, Contractionary Monetary Policy, Open Market
Operations, Changing the Discount Rate, Changing the Required Reserve Ratio, Coordination
of Fiscal and Monetary Policy, Quantity Theory of Money
The Federal Reserve has three general tools of monetary policy at their disposal. The Fed
can engage in open market operations, change the discount rate, and change the required
reserve ratio. Each of these can be used to expand or contract the money supply to stabilize
prices and move the economy to full employment. We first look at the intended effects of
expansionary and contractionary monetary policy, and then investigate each of the tools in
more detail.
Expansionary Monetary Policy
Unlike fiscal policy, which has a relatively direct impact on spending, aggregate demand,
real GDP, unemployment, and the price level, monetary policy affects the economy by
changing interest rates in the money market. Expansionary monetary policy is designed to
fix a recession and increase aggregate demand, lower the unemployment rate, and increase
real GDP. By increasing the money supply, the interest rate is lowered. A lower rate of
interest increases private consumption and investment, which shifts the aggregate demand
curve to the right. This process is illustrated in Figures 11.5 and 11.6.
KEY IDEA
MS MS
MD
Money
Nominal Interest %
Figure 11.5
Contractionary Monetary Policy
As you might imagine, contractionary monetary policy has the opposite effect as expan-
sionary and is designed to avoid inflation by decreasing aggregate demand, which lowers
the price level and decreases real GDP back to the full employment level. By decreasing
the money supply, the interest rate is increased. A higher rate of interest decreases private
consumption and investment, which shifts the aggregate demand to the left. This process
is illustrated in Figures 11.7 and 11.8.
