Characteristics of Expansionary & Contractionary Monetary Policy
Monetary policy refers to a set of actions by which central banks determine the supply and availability of money, as well as the costs of borrowing (interest rates). In the United States, the Federal Reserve is in charge of monetary policy. Central banks such as the Fed can use expansionary or contractionary policy tools to affect a nation's money supply.
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Types
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The three main instruments of monetary policy are changing reserve requirements, changing the discount rate, and buying and selling government bonds (also called "open market operations"). Reserve requirements refer to the minimum amount of customers' deposits banks must hold in reserve instead of lending out. The discount rate is the interest rate that a central bank such as the Fed charges banks that must borrow reserves to meet the reserve requirements. Central banks can use these tools to expand or contract the money supply.
Expansionary Policy
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Expansionary policy increases the supply of money. If the Fed reduces reserve requirements, then banks can lend more of their deposits received. A reduction in the discount rate has similar effects, as a low rate spurs banks to hold fewer reserves because it costs less to borrow money to cover shortfalls.
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Contractionary Policy
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Contractionary monetary policy reduces the supply of money. Central banks often take these actions to reduce inflation. Contractionary actions include increasing banks' reserve requirements, which reduces the amount of money available for lending, and increasing the discount rate, which makes it more costly for banks to fall short of reserve requirements, leading them to engage in less lending. These actions raise interest rates, making borrowing more costly.
Effects of Open Market Operations
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Open market operations can have expansionary or contractionary effects. When a central bank such as the Fed buys government bonds, this increases bond prices; investors then may sell their bonds to take advantage of the higher prices, expanding the money supply. Conversely, selling government bonds lowers bond prices and leads more investors to use their dollars to purchase cheaper government bonds, reducing the money supply.
Theories/Speculation
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Economists offer varying theories on monetary policy. The classical theory, associated with economists such as Adam Smith and David Ricardo, contends that expansionary or contractionary monetary policy results in proportional increases or decreases in the overall level of inflation.
The Keynesian theory, associated with English economist John Maynard Keynes, rejects the classical theory and suggests that the link between monetary policy and the level of economic activity (aka the gross domestic product) is only indirect. Keynesians believe fiscal policy (government taxation and spending) has a greater effect on the economy than monetary policy.
A third theory, monetarism, is associated with free-market economists such as Milton Friedman. Monetarism argues that expansionary policy fuels inflation, while contractionary monetary policy destabilizes the economy. They say that contractionary policies worsened the Great Depression. Monetarist theory advocates a fixed rate of growth in the money supply equal to the rate of growth in the overall economy.
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