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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