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    in which sequence will events occur when the economy adjusts to an expansionary monetary policy, in the short run and then in the long run?

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    28.4 Monetary Policy and Economic Outcomes – Principles of Economics

    28.4 MONETARY POLICY AND ECONOMIC OUTCOMES

    Learning Objectives

    By the end of this section, you will be able to:

    Contrast expansionary monetary policy and contractionary monetary policy

    Explain how monetary policy impacts interest rates and aggregate demand

    Evaluate Federal Reserve decisions over the last forty years

    Explain the significance of quantitative easing (QE)

    A monetary policy that lowers interest rates and stimulates borrowing is known as an expansionary monetary policy or loose monetary policy. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy or tight monetary policy. This module will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. We will conclude with a look at the Fed’s monetary policy practice in recent decades.

    THE EFFECT OF MONETARY POLICY ON INTEREST RATES

    Consider the market for loanable bank funds, shown in Figure 1. The original equilibrium (E0) occurs at an interest rate of 8% and a quantity of funds loaned and borrowed of $10 billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to S1, leading to an equilibrium (E1) with a lower interest rate of 6% and a quantity of funds loaned of $14 billion. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to S2, leading to an equilibrium (E2) with a higher interest rate of 10% and a quantity of funds loaned of $8 billion.

    Figure 1. Monetary Policy and Interest Rates. The original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to the new supply curve (S1) and to a new equilibrium of E1, reducing the interest rate from 8% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%.

    So how does a central bank “raise” interest rates? When describing the monetary policy actions taken by a central bank, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.” We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, interest rates change, as shown in Figure 1. If they do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do.

    Recall that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations.

    Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that are to be repaid over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, but the specific interest rates are set by the forces of supply and demand in those specific markets for lending and borrowing.

    THE EFFECT OF MONETARY POLICY ON AGGREGATE DEMAND

    Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items.

    If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. Figure 2 (a) illustrates this situation. This example uses a short-run upward-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of E0 occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD0) to shift right to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700.

    Source : opentextbc.ca

    Chapter 31: Monetary Policy

    Start studying Chapter 31: Monetary Policy - ECON200. Learn vocabulary, terms, and more with flashcards, games, and other study tools.

    Chapter 31: Monetary Policy - ECON200

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    The Phillips curve graphs the relationship between which two variables?

    Click card to see definition 👆

    the unemployment rate

    the inflation rate

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    In which sequence will events occur when the economy adjusts to an expansionary monetary policy, in the short run and then in the long run?

    Click card to see definition 👆

    the Fed, increase, sticky, produce, in the long run

    Click again to see term 👆

    1/20 Created by Rennagiro

    Terms in this set (20)

    The Phillips curve graphs the relationship between which two variables?

    the unemployment rate

    the inflation rate

    In which sequence will events occur when the economy adjusts to an expansionary monetary policy, in the short run and then in the long run?

    the Fed, increase, sticky, produce, in the long run

    Suppose you own a small business and have been thinking about expanding production, including hiring more workers. Until recently, interest rates at your bank have been too high for you to obtain a loan. However, the central bank decides to expand the money supply, which lowers interest rates to a level where you can take out a loan and expand production. Select the ways in which your actions affect the macroeconomy.

    Aggregate demand increases.

    Unemployment goes down.

    Investment increases.

    Real GDP increases.

    Which of the following is true in the long run, as depicted in the figure showing the effects of an expansionary monetary policy?

    Real GDP returns to its original level.

    Unemployment returns to its original level.

    The more predictable policy decisions by the Federal Reserve are, the more effective they are.

    False

    Suppose that the nation of Rationalia experiences the inflation rates shown from 2013 through 2015. If the Rationalian citizenry behaves according to the rational expectations theory, what will they expect the inflation rate to be in 2016?

    8%

    Which of the following is true in the long run, following a deliberate expansion of the money supply?

    Real GDP returns to its original level.

    The stimulating effects of the policy action wear off.

    Unemployment returns to its original level.

    The figure depicts the short-term effects of a contractionary monetary policy. Apply the labels to show how each element in the economy is affected.

    goes down

    - quantity of investment demand

    - supply of loanable funds

    - price level - economic output goes up - interest rate - unemployment

    This figure illustrates what happens when the Federal Reserve buys a large amount of Treasury bonds. Place the following events in order.

    The Fed With increase Price across Real impact

    The traditional short-run Phillips curve implies a powerful role for monetary policy. According to the theory, place the events in order based on what happens when the central bank unexpectedly expands the money supply.

    the economic the central bank aggerate the inflation

    Suppose that the nation of Adaptistan experiences the inflation rates shown from 2013 through 2015. If the Adaptistanian citizenry behaves according to the adaptive expectations theory, what will they expect the inflation rate to be in 2016?

    Adaptive expectations theory assumes that inflation will remain at the last known level.3%

    Place in order the events that occur in the short run when the Federal Reserve enacts expansionary monetary policy.

    As the Fed, market, the increased, the aggerate

    Each dot on the figure below represents a year between 1948 and 2015. Place each label on the area of the graph where you would expect to find the most dots for those years.

    6-10 : the 1970s the Great Recession 2-5: 1960 bottom

    Fill in the blanks to complete the passage about monetary neutrality.

    Monetary neutrality is the idea that money is neutral in the (blank). . It is a means of exchanging, tracking, and storing value, but is not a (blank) of value. An economy does not become inherently more or less (blank) by virtue of a change in the amount of money in circulation. Real productivity depends on resources, technology, and (blank).

    long run, source, productive, institutions

    Suppose that in the nation of Adaptistan, the inflation rate is highly variable. Three years' worth of inflation rates are shown in the table.

    Assuming adaptive expectations, the public expected 4% inflation in year 4. This is 6% lower than the actual inflation rate of 10%.the answer is 6%

    Does each statement about inflation listed below have to do with adaptive expectations theory or rational expectations theory? Drag the correct label to each statement.

    adaptive theory

    - Next year is expected to be like this year

    - People underestimate inflation when inflation is accelerating.

    rational theory

    - Next year is expected to depend on who wins the upcoming election.

    - People use all available information

    Which of the following monetary crises are seen as partial causes for the Great Depression?

    money held outside the banking systemlack of deposit insurance

    Source : quizlet.com

    Expansionary Policy Definition

    Expansionary policy is a macroeconomic policy that seeks to boost aggregate demand to stimulate economic growth.

    MONETARY POLICY FEDERAL RESERVE

    Overview CENTRAL BANKS Central Bank

    Central Banks and Interest Rates

    Financial Regulators

    Who Determines Interest Rates?

    Monetary Policy vs. Fiscal Policy

    INTRODUCTION TO THE FED

    1913 Federal Reserve Act

    How the Federal Reserve was Formed

    Federal Reserve Board

    Federal Open Market Committee (FOMC)

    Why Is the Federal Reserve Independent?

    THE FED'S ROLES AND FUNCTIONS

    What Do the Federal Reserve Banks Do?

    The Federal Reserve Chair's Responsibilities

    How the Federal Reserve Creates Money

    Federal Reserve Balance Sheet

    Reserve Requirements

    Reserve Ratio Definition

    Interest Rate Cuts and Consumers

    Fed Fund Rate Hikes and the US Dollar

    Open Market Operations

    Tight Monetary Policy

    Expansionary Policy Taylor's Rule

    Expansionary Policy

    By THE INVESTOPEDIA TEAM Updated November 21, 2020

    Reviewed by MICHAEL J BOYLE

    Fact checked by KATRINA MUNICHIELLO

    What Is an Expansionary Policy?

    Expansionary, or loose policy is a form of macroeconomic policy that seeks to encourage economic growth. Expansionary policy can consist of either monetary policy or fiscal policy (or a combination of the two). It is part of the general policy prescription of Keynesian economics, to be used during economic slowdowns and recessions in order to moderate the downside of economic cycles.

    KEY TAKEAWAYS

    Expansionary policy seeks to stimulate an economy by boosting demand through monetary and fiscal stimulus.

    Expansionary policy is intended to prevent or moderate economic downturns and recessions.

    Though popular, expansionary policy can involve significant costs and risks including macroeconomic, microeconomic, and political economy issues.

    0 seconds of 0 secondsVolume 75%

    1:43

    Expansionary Policy

    Understanding Expansionary Policy

    The basic objective of expansionary policy is to boost aggregate demand to make up for shortfalls in private demand. It is based on the ideas of Keynesian economics, particularly the idea that the main cause of recessions is a deficiency in aggregate demand. Expansionary policy is intended to boost business investment and consumer spending by injecting money into the economy either through direct government deficit spending or increased lending to businesses and consumers.

    From a fiscal policy perspective, the government enacts expansionary policies through budgeting tools that provide people with more money. Increasing spending and cutting taxes to produce budget deficits means that the government is putting more money into the economy than it is taking out. Expansionary fiscal policy includes tax cuts, transfer payments, rebates and increased government spending on projects such as infrastructure improvements.

    For example, it can increase discretionary government spending, infusing the economy with more money through government contracts. Additionally, it can cut taxes and leave a greater amount of money in the hands of the people who then go on to spend and invest.

    Expansionary monetary policy works by expanding the money supply faster than usual or lowering short-term interest rates. It is enacted by central banks and comes about through open market operations, reserve requirements, and setting interest rates. The U.S. Federal Reserve employs expansionary policies whenever it lowers the benchmark federal funds rate or discount rate, decreases required reserves for banks or buys Treasury bonds on the open market. Quantitative Easing, or QE, is another form of expansionary monetary policy.

    On August 27, 2020 the Federal Reserve announced that it will no longer raise interest rates due to unemployment falling below a certain level if inflation remains low. It also changed its inflation target to an average, meaning that it will allow inflation to rise somewhat above its 2% target to make up for periods when it was below 2%.

    For example, when the benchmark federal funds rate is lowered, the cost of borrowing from the central bank decreases, giving banks greater access to cash that can be lent in the market. When reserve requirements decline, it allows banks to lend a higher proportion of their capital to consumers and businesses. When the central bank purchases debt instruments, it injects capital directly into the economy.

    The Risks of Expansionary Monetary Policy

    Expansionary policy is a popular tool for managing low-growth periods in the business cycle, but it also comes with risks. These risks include macroeconomic, microeconomic, and political economy issues.

    Gauging when to engage in expansionary policy, how much to do, and when to stop requires sophisticated analysis and involves substantial uncertainties. Expanding too much can cause side effects such as high inflation or an overheated economy. There is also a time lag between when a policy move is made and when it works its way through the economy.

    This makes up-to-the-minute analysis nearly impossible, even for the most seasoned economists. Prudent central bankers and legislators must know when to halt money supply growth or even reverse course and switch to a contractionary policy, which would involve taking the opposite steps of expansionary policy, such as raising interest rates.

    Even under ideal conditions, expansionary fiscal and monetary policy risk creating microeconomic distortions through the economy. Simple economic models often portray the effects of expansionary policy as neutral to the structure of the economy as if the money injected into the economy were distributed uniformly and instantaneously across the economy.

    Source : www.investopedia.com

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