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monetary policy

monetary policy Bryan Hatch, Economics 2020, MWF 9 a.m. Article # 7, Martin Feldstein, “Tax Cuts, Rate Cuts Put the Economy Back on Track,” The Wall Street Journal, March 13, 2002, p. A 18. According to Mr. Feildstein, the recent tax cuts and interest rate cuts have helped put the economy back on track. He says that the strong growth of the U.S. economy in recent months is neither an illusion nor an accident, but it reflects good monetary and fiscal policy over the past year. He says that there has been a key surge in consumer spending, and that the main reason for that surge was the enactment of the tax cut in early 2001. He also stated that the repeated reductions by the Fed in short-term interest rates supported the expansionary effect of the tax cut. Even though the interest rate reductions were not enough to prevent the recession that began in March of last year, the lower interest rates did stimulate consumer spending through a variety of channels. This article is also a good example of how the aggregate demand curve can be shifted by the determinant of monetary policy. Please refer again back to article #4, which explains the principle of the aggregate demand curve. By definition, Monetary Policy is a policy influencing the economy through changes in the banking system’s reserves that influence the money supply and credit availability in the economy. The purpose of monetary policy is to improve the economy by either increasing or decreasing the real income (or GDP) of the U.S. economy so that the economy is running at its potential. The Federal Reserve (The Fed) is responsible for conducting monetary policy for the United States Economy. There are three ways that the Fed conducts monetary policy: 1) Changing the reserve requirement. 2) Executing open market operations (buying and selling bonds). 3) Changing the discount rate. This article talks about the Fed decreasing the discount rate to stimulate the economy. The discount rate is the rate of interest the Fed charges for loans it makes to banks. An increase in the discount or interest rates makes it more expensive for banks to borrow from the Fed. A discount rate decrease makes it less expensive for banks to borrow. This article is talking about how the Fed decreased the discount rate making it easier for banks to borrow, increasing the money supply. The decrease in the discount rate increases the money supply because it lowers the bank=s costs and allows it to borrow more money from the Fed. More reserves are in the system, so the money supply increases and the interest rate banks charge customers also decreases. Because the interest rate that banks charge their customers has just decreased this is going to cause an increase in Investments. Obviously, the lower the market interest rate, or the interest rate that banks charge customers, the more people are going to invest. So, in other words a decrease in the discount rate is going to cause an increase in the quantity of Investments. As explained in a previous article (refer to article #4), this increase in Investments is one of the determinants for a shift forward in the Aggregate demand curve. Aggregate demand consists of the sum of consumption, investment, government, and net exports. So it is pretty straightforward that an increase in investment will cause an increase in the Aggregate demand. A shift forward in Aggregate demand causes the real output (or GDP) of the economy to increase. The aggregate demand curve will continue to shift forward until reaches the full potential GDP. The full potential GDP is where the economy is running at its full potential. Trying to make the economy reach its full potential is the purpose for monetary policy and the reason the Fed decreases or increases the discount rate. Aggregate demand graph with monetary policy. The process of how the monetary policy of decreasing the discount rate eventually increases the real output or GDP of an economy can be shown graphically by using a three-graph set: The decrease in the discount rate causes an increase in the money supply (Step 1, MS1 to MS2). This increase in money supply causes a decrease in the market interest rate (Step 2, i1 to i2). The decrease in the market interest rate (the rate banks charge their customers) (Step 2, i1 to i2), causes an increase in total Investments (I1 to I2). The increase of total Investments causes a shift forward of the aggregate demand curve (Step 3, AD1 to ADn). The Aggregate demand curve will continue to increase until the real output (Yreal) or GDP reaches the full potential (). This is shown by Step 4, the movement from Yreal to . The price level does not change in the short-run as shown by no shift of the SRAS (refer to article #5 for an explanation of the SRAS). Bibliography:

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