Monetary policy is government change in money supply to influence the economy, to solve economies problems. Economies problems include inflation in boom, unemployment etc. change in the money supply move interest rates up or down and affect spending in sectors such as business investment, housing, and foreign trade. Monetary policy has an important effect on both actual GDP and potential GDP.
Q2. If the government wanted to slow down the economy (when in boom) how could it utilize monetary policy?
Monetary policy is government change in money supply to influence the economy, to solve economies problems. Economies problems include inflation in boom; unemployment etc. monetary policy has three major instruments. They are given below:-
Open market operations
Open market operations are just that, the buying or selling of Government bonds by the Central Bank in the open market. If the Central Bank were to buy bonds, the effect would be to expand the money supply and hence lower interest rates; the opposite is true if bonds are sold. This is the most widely used instrument in the day to day control of the money supply due to its ease of use, and the relatively smooth interaction it has with the economy as a whole.
Discount rate policy
Discount rate policy is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates. This enables the institutions to vary credit conditions. That is the amount of money they have to loan out. There by discount rate affecting the money supply. It is of note that the Discount rate policy is the only instrument which the Central Banks do not have total control over.
Reserve requirements are a percentage of commercial banks, other depository institutions demand, and deposit liabilities that must be kept on deposit at the Central Bank as a requirement of Banking Regulations. This percentage may be changed by the Central Bank at any time, thereby affecting the money supply and credit conditions. If the reserve requirement percentage is increased, this would reduce the money supply by requiring a larger percentage of the banks, and depository institutions, demand deposits to be held by the Central Bank, thus taking them out of supply. As a result, an increase in reserve requirements would increase interest rates, as less currency is available to borrowers. This type of action is only performed occasionally as it affects money supply in a major way. Altering reserve requirements is not merely a short-term corrective measure, but a long-term shift in the money supply.
Utilization of monetary policy in boom:-
When boom is take place in an economy then inflation rate become high. That causes reduction of money supply. Then the government sells all his securities. People are reducing their in bank but intends to by more securities. In recession needs to simulate economy by buying securities and increase money supply.
In the following figure assume that economy is in boom. The x axis of the figure is representing money supply (MS) and the y axis is representing rate of interest (Rofi).
In boom money supply decreases as government sell securities. That causes decrease of discount rate and decrease of reserve requirement. As money supply decreases rate of interest goes up that shown in the above figure. In the above figure as rate of interest (Rofi) goes up from Rofi1 to Rofi2 that’s why money supply goes down from MS1 to MS2.
If we assume that money supply is fixed. Then because of increase of rate of interest also causes decrease on investment and consumption on durable goods. If rate of interest goes up then the value of bonds, wealth also goes down.
In conclusion I would like to say that, inflation is the greatest problem of boom. It brings money supply down. It causes high rate of inflation that causes low investment, low consumption. That also causes reduction of aggregate demand. Monetary can also be used to ignite or slow the economy but is controlled by the central bank, the Federal Reserve with the ultimate goal of creating an easy money environment. It is use full to use monetary policy in boom. That’s mean monetary policy has proven to have some influence and impact on the economy and equity and fixed income markets.