Monetary Policy

We now understand that investment is a key determinant of equilibrium income. The interest rate in turn influences investment, and the interest rate is influenced by the money supply by way of the liquidity preference relation.

This opens the possibility for the government (or, more exactly, the monetary authority) to influence production and employment by manipulating the money supply. This is called monetary policy.

Monetary Policy

Changes in central bank policy or in bank reserves, designed to influence the interest rate and thus investment, production and employment, are called monetary policy.

For example, if the monetary authority in the United States, the Federal Reserve, wants to stimulate increased production, they would do it by increasing bank reserves. Recall, the method of increasing bank reserves is to buy bonds from the public or from the banks, since the Fed pays for the bonds with deposits in the Federal Reserve Bank System, and these deposits are bank reserves. The banks then expand the money supply by lending some multiple of the increased reserves. This drives down the real interest rate. In response to the lower interest rate, investment rises, ceteris paribus. This is called "expansionary monetary policy." Recall, earlier in this chapter we hinted that it might be possible to stimulate increased production by indirectly stimulating investment. Expansionary monetary policy does this, according to the Complete Keynesian Model.

Monetary Policy Example