Economics / Unit 10: The Federal Reserve and Monetary Policy
10.5 Expansionary and Contractionary Monetary Policy
Notes
| Policy | Used when | Fed actions | Expected effects |
|---|---|---|---|
| Expansionary ("easy money") | recession, high unemployment | buy securities, lower rate targets | lower interest rates, more borrowing and spending, more jobs |
| Contractionary ("tight money") | high inflation | sell securities, raise rate targets | higher interest rates, less borrowing and spending, lower inflation |
- Chain of effects: lower rates → cheaper loans for homes, cars and business equipment → more spending → higher output and employment. Too much stimulus can cause inflation.
- The quantity theory of money: $MV = PQ$, where $M$ is the money supply, $V$ is velocity (how often each dollar is spent), $P$ is the price level and $Q$ is real output. If $V$ and $Q$ stay steady, faster growth in $M$ means higher prices.
- Worked example: if $M = 2$ trillion dollars and $V = 5$, then nominal GDP ($PQ$) is $2 \times 5 = 10$ trillion dollars.
- History: under Chair Paul Volcker, the Fed raised interest rates sharply around 1980 to fight the high inflation of the 1970s; a recession followed, and inflation fell. In 2008 and again in 2020, the Fed cut short-term rates to near zero to support the economy.
Practice
The economy is in a recession with high unemployment. Which monetary policy would the Fed most likely choose?
Lower rates encourage borrowing and spending, which supports jobs.
If the money supply is $3 trillion and velocity is 6, what is nominal GDP according to $MV = PQ$?
$PQ = MV = 3 \times 6 = 18$.
When the Fed raises interest rates, which outcome is most likely in the short run?
Higher rates make loans more expensive, cooling demand.
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