Monetary Policy

Monetary policy is conducted by a nation's central bank. In the U.S., monetary policy is carried out by the Fed. The Fed has three main instruments that it uses to conduct monetary policy: open market operations, changes in reserve requirements, and changes in the discount rate. Recall from the earlier discussion of money and banking that open market operations involve Fed purchases and sales of U.S. government bonds. When the Fed purchases government bonds, it increases the reserves of the banking sector, and by the multiple deposit expansion process, the supply of money increases. When the Fed sells some of its stock of U.S. government bonds, the end result is a decrease in the supply of money. If the Fed increases bank reserve requirements, the banking sector's excess reserves are reduced, leading to a reduction in the supply of money; a decrease in reserve requirements induces an increase in the supply of money.


The discount rate is the interest rate the Fed charges banks that need to borrow reserves in order to meet reserve requirements. From time to time, unanticipated withdrawals leave banks with insufficient reserves. Banks can make up for deficiencies in their required reserves by borrowing from the Fed at the discount rate. If the Fed sets the discount rate high relative to market interest rates, it becomes more costly for banks to fall below reserve requirements. Accordingly, banks will hold more excess reserves, which tends to reduce the multiple expansion of deposits and the supply of money. Similarly, when the discount rate is low relative to market interest rates, banks tend to hold fewer excess reserves, allowing for greater deposit expansion and an increase in the supply of money.

Expansionary and contractionary monetary policy. The Fed is engaging in expansionary monetary policy when it uses any of its instruments of monetary policy in such a way as to cause an increase in the supply of money. The Fed is said to engage in contractionary monetary policy when it uses its instruments to effect a reduction in the supply of money. Classical view of monetary policy. The classical economists' view of monetary policy is based on the quantity theory of money. According to this theory, an increase (decrease) in the quantity of money leads to a proportional increase (decrease) in the price level. The quantity theory of money is usually discussed in terms of the equation of exchange, which is given by the expression 


In this expression, P denotes the price level, and Y denotes the level of current real GDP. Hence, PY represents current nominal GDP; M denotes the supply of money over which the Fed has some control; and V denotes the velocity of circulation, which is the average number of times a dollar is spent on final goods and services over the course of a year. The equation of exchange is an identity which states that the current market value of all final goods and services—nominal GDP—must equal the supply of money multiplied by the average number of times a dollar is used in transactions in a given year. The quantity theory of money requires two assumptions, which transform the equation of exchange from an identity to a theory of money and monetary policy.

Recall that the classical economists believe that the economy is always at or near the natural level of real GDP. Accordingly, classical economists assume that Y in the equation of exchange is fixed, at least in the short‐run. Furthermore, classical economists argue that the velocity of circulation of money tends to remain constant so that V can also be regarded as fixed. Assuming that both Y and V are fixed, it follows that if the Fed were to engage in expansionary (or contractionary) monetary policy, leading to an increase (or decrease) in M, the only effect would be to increase (or decrease) the price level, P, in direct proportion to the change in M. In other words, expansionary monetary policy can only lead to inflation, and contractionary monetary policy can only lead to deflation of the price level.

Keynesian view of monetary policy. Keynesians do not believe in the direct link between the supply of money and the price level that emerges from the classical quantity theory of money. They reject the notion that the economy is always at or near the natural level of real GDP so that Y in the equation of exchange can be regarded as fixed. They also reject the proposition that the velocity of circulation of money is constant and can cite evidence to support their case.

Keynesians do believe in an indirect link between the money supply and real GDP. They believe that expansionary monetary policy increases the supply of loanable funds available through the banking system, causing interest rates to fall. With lower interest rates, aggregate expenditures on investment and interest‐sensitive consumption goods usually increase, causing real GDP to rise. Hence, monetary policy can affect real GDP indirectly.

Keynesians, however, remain skeptical about the effectiveness of monetary policy. They point out that expansionary monetary policies that increase the reserves of the banking system need not lead to a multiple expansion of the money supply because banks can simply refuse to lend out their excess reserves. Furthermore, the lower interest rates that result from an expansionary monetary policy need not induce an increase in aggregate investment and consumption expenditures because firms' and households' demands for investment and consumption goods may not be sensitive to the lower interest rates. For these reasons, Keynesians tend to place less emphasis on the effectiveness of monetary policy and more emphasis on the effectiveness of fiscal policy, which they regard as having a more direct effect on real GDP.

Monetarist view of monetary policy. Since the 1950s, a new view of monetary policy, called monetarism, has emerged that disputes the Keynesian view that monetary policy is relatively ineffective. Adherents of monetarism, called monetarists, argue that the demand for money is stable and is not very sensitive to changes in the rate of interest. Hence, expansionary monetary policies only serve to create a surplus of money that households will quickly spend, thereby increasing aggregate demand. Unlike classical economists, monetarists acknowledge that the economy may not always be operating at the full employment level of real GDP. Thus, in the short‐run, monetarists argue that expansionary monetary policies may increase the level of real GDP by increasing aggregate demand. However, in the long‐run, when the economy is operating at the full employment level, monetarists argue that the classical quantity theory remains a good approximation of the link between the supply of money, the price level, and the real GDP—that is, in the long‐run, expansionary monetary policies only lead to inflation and do not affect the level of real GDP.

Monetarists are particularly concerned with the potential for abuse of monetary policy and destabilization of the price level. They often cite the contractionary monetary policies of the Fed during the Great Depression, policies that they blame for the tremendous deflation of that period. Monetarists believe that persistent inflations (or deflations) are purely monetary phenomena brought about by persistent expansionary (or contractionary) monetary policies. As a means of combating persistent periods of inflation or deflation, monetarists argue in favor of a fixed money supply rule. They believe that the Fed should conduct monetary policy so as to keep the growth rate of the money supply fixed at a rate that is equal to the real growth rate of the economy over time. Thus, monetarists believe that monetary policy should serve to accommodate increases in real GDP without causing either inflation or deflation.