Monetary policy tools | Financial sector | AP Macroeconomics | Khan Academy

What we're going to do in this video is think about monetary policy, which is policy that a central bank can use to affect the economy in some way. This is often contrasted with fiscal policy, and that would be a government deciding to tax or spend in some way in order to make adjustments to an economy.

But to help us think through monetary policy, let's bring up our model for the money market. Just as a little bit of a review here, on the horizontal axis I have the quantity of money. Unless we could imagine that, say, the M1, which is cash in circulation and checkable deposits. And then here in the vertical axis we have our nominal interest rate.

In this model, we have assumed a perfectly inelastic money supply. That's why we have this vertical line, which isn't exactly how the world works, but we'll go with that for the sake of this video. Then we have the demand curve for money. At high nominal interest rates, the cost, the opportunity cost of keeping cash is very high, so people would not want to keep much of it around. When nominal interest rates are low, the opportunity cost or at least the perceived opportunity cost of holding cash is a lot lower, so people might want to hold more of it.

So you have a higher demand for money. This point where the supply and the demand intersect — we have seen this before. This point of equilibrium, we see that that would result in our equilibrium nominal interest rate. But let's say this is the world that we are in, and we are in a recessionary or a negative output gap, and you are the central bank of this country. What could you do?

Well, in general, you’d say, "Well, it would be nice if interest rates, if nominal interest rates were lower," then maybe people would be willing to borrow more. There'd be more of a demand for money, and they would use that money in order to make investments or in order to consume more, and we could close that recessionary gap.

But how would you lower interest rates? Well, one way would be to increase the money supply. If we could shift this vertical line to the right somehow, but how would you do that? We often talk about central banks printing money, but how do they get that money actually into circulation? How do they actually increase the money supply?

Well, there's a couple of tools at their disposal. One is the idea of open market operations. This is the tool that central banks most typically use. Let's say that this is a bond that I currently own, and a bond is a loan to some entity. This paper says, "Hey, that entity is going to pay you back with interest at some point in the future."

Let's say this is a government bond; let's say it's to the U.S. government. What the Federal Reserve might do in the United States — the central bank, and this is how most central banks work — the Federal Reserve says, "Hey, I want to increase the money supply," and so they say, "Hey, I'm going to go into the open market and buy a bond.”

So I might not know who's buying that bond, but it happens to be the Federal Reserve. Instead of selling it to someone else, who would give me cash that's already in circulation, the Federal Reserve would be introducing new cash into circulation.

This might be money that they just printed — and I'll say printed in quotes because there's not a lot of physical cash, or at least as much as there used to be. These could just be digital numbers in banking accounts at certain places, but it has the same functional idea that this is part of the monetary base.

Then we've talked about this before: you have a money multiplier. I would put this into a bank. The bank would loan out a proportion of that based on the reserve requirements, and then whoever gets that would deposit in a bank. Then that bank could loan out a certain proportion.

Let's say that the central bank bought this from me for one thousand dollars, and let's say that our current reserve requirement is equal to twelve point five percent. Well, the effect on the money supply over here won't just be one thousand dollars; instead, we would move a thousand dollars times the money multiplier, and so this would be equal to — so we would have one thousand dollars, and what's the multiplier going to be?

Well, it's going to be one over twelve point five percent, zero point one two five, one over zero point one two five. This right over here is eight, so the money multiplier here is eight. So the effect of buying that thousand dollar bond with new printed currency, so to speak, would actually be to increase the money supply by eight thousand dollars.

An eight-thousand dollar increase in money supply, and obviously, eight thousand dollars is not going to make a big deal to an economy like the United States. But imagine if this was 100 billion dollars; well then this would be 800 billion dollars right over here. What would happen to this curve? Well, it would move over. Let's say it moves over here, and so this is the money supply curve 2.

Now, what is our equilibrium interest rate? Well, our equilibrium interest rate, our nominal interest rate, has now gone down — r2. This would hopefully have the effect that the central bank wants that, "Hey, now that nominal interest rates have gone down, people might borrow more for more consumption, for more investment, and close that negative output gap."

It can work the other way as well. Imagine if in this situation right over here, we were in an inflationary output gap, a positive output gap; the economy was overheating in some way, and the central bank wanted to cool things down. Well, the way they could do is they could say, "Well, if interest rates were a little bit higher, that might slow things down; there might be less consumption, less investment."

How would they do that? Well, instead of what they did here where they bought bonds to inject cash, they could do the opposite. They could take bonds that the central bank has, and they could sell those bonds, and then that would take cash out of the system. By taking that cash out of the system, it would take reserves out of the system, and it would have the opposite effect.

It would shift the money supply to the left, and then you would have the effect of raising rates. Now, another way of shifting the money supply to the right or the left, here increasing or decreasing it, is by changing the actual reserve requirement. This is done less frequently than the open market operations, but we'll see that that could have the same effect.

If the central bank, which can set the reserve requirement, were to change it from twelve and a half percent and were to instead make it, let's say, ten percent, well then the money multiplier — when we've done the math in other videos — it would go from one over twelve point five percent. It would go from eight to one over ten percent to ten.

So the existing reserves, instead of having an eight times multiplier on them, you would have a ten times multiplier on them. Once again, that would have the effect of increasing the money supply. Now, another tool that's sometimes associated with monetary policy is setting the discount rate.

Now, the discount window at the Federal Reserve in the United States isn't used in situations to affect monetary policy so much as really being a mechanism of safety for our financial system. If a bank is running out of reserves, and so they can still hold up their commitments to folks, they can go to the discount window of the Federal Reserve and borrow money directly from the Fed.

The Federal Reserve can set this discount rate, but it really becomes operational during emergencies. When you hear about the Federal Reserve setting the rate, they're really talking about the federal funds rate. Federal funds — this is the rate at which banks lend reserves to each other overnight.

The banks are going to be lending to each other at slightly different rates, but what the Federal Reserve, the central bank, will do is they'll set a target federal funds rate. So what they will do is they will target a federal funds rate and typically use open market operations to make that target a reality.

Now, the last thing I want you to appreciate in this discussion of monetary policy, the things that the Federal Reserve can do to increase or decrease the money supply, to decrease or increase nominal interest rates, is to think about how quickly these things might happen and how quickly their effects might be.

There's oftentimes a lag here; it might take a little time for the central bank to realize, "Hey, it looks like we're in an inflationary situation; maybe we got to decrease the money supply a little bit. Maybe we got to take a little bit of reserves out of the system," or the other way around to realize that they're in a recession. So there's usually a lag there, and then even once they act — they enact this monetary policy — it takes time for it to fully impact the system.

It takes time for the interest rates to truly come down, and even more, once the interest rates are down, it might take time for people to realize that "Hey, maybe I want to borrow now," and "What would I use that money for?" and that for that to actually impact the economy.