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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 [link] . The original equilibrium (E 0 ) 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 (S 0 ) to S 1 , leading to an equilibrium (E 1 ) 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 (S 0 ) to S 2 , leading to an equilibrium (E 2 ) with a higher interest rate of 10% and a quantity of funds loaned of $8 billion.

Monetary policy and interest rates

This graph shows how monetary policy shifts the supply of loanable funds.
The original equilibrium occurs at E 0 . An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S 0 ) to the new supply curve (S 1 ) and to a new equilibrium of E 1 , 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 (S 0 ) to the new supply (S 2 ), 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 [link] . 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.

Questions & Answers

Don't damend work in inflation
Mishael Reply
conceptand variable of macro economics
Bittu Reply
macro economics is the study of general factors in an economy.
what is fiscal policy?
fiscal policy refers to the use of government spending,taxation and borrowing to affect economic activity ,monetary policy on the other hand, entails the manipulation of interest rates.
A lots of thanks
you are welcome
Very informative talukder
yes Jafta
So scarcity will always be a problem, is something that can't be solved due to specialization of labor and choice?
yes right Jafta
good definition Jata♥♥
how are you all
Kindly explain or give example of Voluntary unemployment.
when unemployment doesn't choose a accept job at wage of rate
Thanks Talukder
macroeconomics is not too hard
wow Omar, ur so helpful lol🤣
good ho every one
what's up guys■■
I want someone to tell me everything about the inflation and and hyber inflation is plz
dot US Army higher South Korean citizen for the US base South Korea and pay them 50000 as a result
farzana Reply
What is production possibility frontier
adewale Reply
Production possibility frontier is a curve depicting all maximum output possibilities for two goods, given a set of inputs consisting of resources and other factors. The production possibility curve is frontir that all inputs are used efficiently.
what are some examples of a monetary policy?
Viccey Reply
expansionary policy contractionary policy
what is scarcity
van Reply
scarcity is like having so much of goods and services to access and you want them
how to calculate GDP
Gdp =c+I +nx +G
GDP=rent+interest+wages and salaries+profit
what are the assumptions of the marginal utility theory ?
GDPfc=GDI+stock dep-stock app+- residual errors
marginal cost and marginal benefits
Racheal Reply
what is unemployment
Nazer Reply
The total number of people in the labor force who are willing to work and actively looking for a job but cannot find one.
Heckchers Ohlin theory of International trade
Lal Reply
but if I may ask what brings this poverty in existence and how can such actions be deminish in our generation
Philemon Reply
Poverty comes from many factors, ranging from very low income for the households sector (purchasing power is low), basic needs such as safe drinking water, lack of sustainable development goals (roads, agriculture, technology, power, etc), business sector is poor, etc
Such action can be diminished by effectively and efficiently using the four (4) factors of production. Land, Labor , Capital and Technology.
Poverty - Increase in the cost of living without subsequent increase in the amount of minimum wage. Poverty can be reduced extremely if the minimum wage equals or equals more than the cost of living.
land labour capital and organisation factors of production
what are positive and normative statements
Alethia Reply
positive is realistic normative is imaginary
give basic idea about India's national income
Maloy Reply
what are the sources of recessions and booms
Zweli Reply
A few years ago, Ama paid $500 to put together a record collection. Today she sold her albums at a garage sale for $100. how does the same affect GDP?
teresa Reply
It saves time its creates more employment
Gold Reply
Scarcity means human wants exceeds the resources needed to satisfy them 1. Limited resources 2. Numerous human wants
Scarcity means shortage!!!
Gold you're knowlwgist bro keep going lion
hmm am fresh here oh
Being newest means u have it all!!!
where you from university of malakand.or where are you.
What is mean by small open economy ?

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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