Macroeconomics
Alternatively, anincreaseintherequiredreserveisacontractionarymonetarypolicytool thatresults in the opposite effects: rr ↑ → deposits ↓ → monetary base ↓ → loans ↓ → moneysupply ↓ All the tools described thus far are utilized bytheFedtoimplementmonetarypolicyduringperiodsof macroeconomic instability, which can include high inflation or high unemployment. In general, expansionarymonetarypolicytoolsareemployedwhenoutputistoolow,unemploymentistoohigh,or inflation is too low. Conversely, contractionary monetary policy is applied when output is too high, unemployment is too low, or inflation is too high. These processes will be explained in detail in Chapter 5. Keepinmindthatthesetoolsandtheirobjectivesdifferbetweenbankingsystemswithlimitedorample reserves. Checkpoint Quiz 1: How are the discount rate, the federal funds rate, the IOR, and the rr used to implement a contractionary monetary policy? (Checkpoint answers are located at the end of the chapter under the review question answers.) L. Limitations of Monetary Policy Monetary policy has limitations that reduce its effectiveness in solving economic problems and closing output gaps. These limitations include the following:
● Lags between the time it takes to recognize economic problems and the time it takes the economy to adjust to the policy action intended to solve it. ● The effects of a change in interest rates, such as those resulting from OMOs, do not manifest instantly. For example, when OMOs influence the overnight rate (policy or federal funds rate), it takes time for adjustments to transmit to other interest rates. Even after these interest rates have adapted, it still requires time for investments to respond to the new interest rate.
M. Quantity Theory of Money Sincemonetarypolicyusesmoneysupplytoaffectmacroeconomicaggregatesincludingthepricelevel, some economists, called the monetarists, use the quantity theory of money to argue that excessive money supply increases price levels, and is therefore a reason behind inflation in an economy.
This theory is based on the following equation:
M × V = P × Y
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