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Monetary policy tools | Financial sector | AP Macroeconomics | Khan Academy - YouTube
Channel: Khan Academy
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what we're going to do in this video is
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think about
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monetary policy which is policy that a
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central bank can use to affect the
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economy in some way this is often
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contrasted with fiscal policy and that
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would be a government deciding to tax or
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spend in some way in order to make
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adjustments to an economy but to help us
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think through monetary policy let's
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bring up our model for the money market
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and just as a little bit of a review
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here on the horizontal axis i have the
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quantity of money unless we could
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imagine that say the m1 which is cash in
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circulation and checkable deposits and
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then here in the vertical axis we have
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our nominal interest rate in this model
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we have assumed a perfectly inelastic
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money supply that's why we have this
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vertical line which isn't exactly how
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the world works but we'll go with that
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for the sake of this video and then we
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have the demand curve for money at high
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nominal interest rates the cost the
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opportunity cost of keeping cash is very
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high so people would not want to keep
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much of it around and then when nominal
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interest rates are low the opportunity
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cost or at least the perceived
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opportunity cost of holding cash is a
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lot lower so people might want to hold
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more of it and so you have a higher
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demand for money and this point where
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the supply and the demand intersect we
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have seen this before this point of
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equilibrium we see that that would
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result in our equilibrium nominal
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interest rate
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but let's say this is the world that we
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are in and we are in a recessionary or a
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negative output gap and you are the
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central bank of this country what could
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you do
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well in general you say well it would be
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nice if interest rates if nominal
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interest rates were lower then maybe
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people would be willing to borrow more
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there'd be more of a demand for money
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and they would use that money in order
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to make investments or in order to
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consume more and we could close that
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recessionary gap
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but how would you lower interest rates
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well one way would be to increase the
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money supply if we could shift this
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vertical line to the right somehow
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but how would you do that we often talk
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about central banks printing money but
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how do they get that money actually into
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circulation how do they actually
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increase the money supply well there's a
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couple of tools at their disposal one is
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the idea of open market operations
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open
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market
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operations and this is the tool that
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central banks most typically use
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let's say that this is a bond that i
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currently
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own
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and a bond is a loan to some entity and
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this paper says hey that entity is going
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to pay you back with interest at some
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point in the future and let's say this
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is a government bond let's say it's to
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the u.s government what it what the
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federal reserve might do in the united
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states the central bank and this is how
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most central banks work the federal
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reserve says hey i want to increase the
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money supply and so they say hey i'm
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going to go into the open market and buy
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a bond so i might not know who's buying
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that bond but it happens to be the
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federal reserve and so instead of
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selling it to someone else who would who
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would give me cash that's already in
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circulation the federal reserve would be
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introducing new cash into circulation
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this might be money that they just
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printed and i'll say printed in quotes
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because there's not a lot of physical
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cash or at least as much as there used
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to be these could just be digital
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numbers in banking accounts at certain
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places but it has the same functional
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idea that this is part of the monetary
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base and then we've talked about this
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before you have a money multiplier i
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would put this into a bank the bank
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would loan out a proportion of that
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based on the reserve requirements and
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then whoever gets that would deposit in
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a bank and then that bank could loan out
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a certain proportion let's say that the
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central bank bought this from me for
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one thousand
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one thousand dollars and let's say that
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our current reserve requirement
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is equal to twelve point five percent
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well the effect on the money supply over
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here won't just be one thousand dollars
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instead we would move a thousand dollars
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times the money multiplier and so this
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would be equal to
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so we would have one thousand dollars
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and what's the multiplier going to be
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well it's going to be one over twelve
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point five percent zero point one two
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five
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one over zero point one two five this
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right over here is eight so the money
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multiplier here is eight so the effect
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of buying that thousand dollar bond with
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new printed currency so to speak printed
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cash so to speak would actually be to
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increase the money supply by eight
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thousand dollars
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eight
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thousand dollar increase in money supply
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and obviously eight thousand dollars is
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not going to make a big deal to an
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economy like the united states but
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imagine if this was 100 billion dollars
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well then this would be 800 billion
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dollars right over here and what would
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happen to this curve
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well it would move
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over let's say it moves over here
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and so this is money supply curve 2
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and then this is m2 and now what is our
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equilibrium interest rate
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well our equilibrium interest rate
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our nominal interest rate has now gone
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down r2 and this would hopefully have
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the effect that the central bank wants
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that hey now that nominal interest rates
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have gone down people might borrow more
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for more consumption for more investment
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and close that negative output gap and
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it can work the other way as well
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imagine if in this situation right over
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here we were in an inflationary output
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gap a positive output gap the economy
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was overheating in some way and the
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central bank wanted to cool things down
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well the way they could do is they could
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say well if interest rates were a little
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bit higher that might slow things down
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there might be less consumption less
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investment how would they do that
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well instead of what they did here where
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they bought bonds to inject cash they
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could do the opposite they could take
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bonds that the central bank has and they
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could sell those bonds and then that
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would take cash out of the system by
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taking that cash out of the system it
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would take reserves out of the system
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and it would have the opposite effect
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and it would shift the money supply to
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the left and then you would have the
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effect of raising rates
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now another way of shifting the money
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supply to the right or the left here
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increasing or decreasing it is by
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changing the actual reserve requirement
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this is done less frequently than the
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open market operations but we'll see
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that that could have the same effect if
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the central bank which can set the
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reserve requirement were to change it
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from 12 and a half percent and were to
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instead make it let's say
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ten percent
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well then the money multiplier
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money
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multiplier
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when we've done the math in other videos
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it would go from one over twelve point
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five percent it would go from eight to
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one over ten percent to ten so the
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existing reserves instead of having an
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eight times multiplier on them you would
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have a ten times multiplier on them and
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once again that would have the effect of
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increasing the money supply
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now another tool that's sometimes
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associated with monetary policy is
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setting the discount rate
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now the discount window at the federal
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reserve in the united states isn't used
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in situations to affect monetary policy
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so much as really being a mechanism of
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of safety for our financial system so if
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a bank is running out of reserves and so
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they can still hold up their commitments
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to folks they can go to the discount
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window of the federal reserve and borrow
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money directly from the fed and the
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federal reserve can set this discount
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rate but it really becomes operational
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during emergencies when you hear about
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the federal reserve setting the rate
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they're really talking about the federal
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funds rate
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federal
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funds
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and this is the rate at which banks lend
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reserves to each other overnight
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and the banks are going to be lending to
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each other at slightly different rates
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but what the federal reserve the central
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bank will do is they'll set a target
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federal funds rate so what they will do
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is they will target a federal funds rate
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and typically use open market operations
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to make that target a reality now the
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last thing i want you to appreciate in
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this discussion of monetary policy the
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things that the federal reserve can do
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to increase or decrease the money supply
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to decrease or increase nominal interest
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rates is to think about
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how quickly these things might happen
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and how quickly their effects might be
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there's oftentimes a lag here it might
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take a little time for the central bank
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to realize hey it looks like we're in an
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inflationary situation maybe we got to
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decrease the money supply a little bit
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maybe we got to take a little bit of
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reserves out of the system or the other
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way around to realize that they're in a
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recession so there's usually a lag there
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and then even once they act they enact
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this monetary policy it takes time for
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it to fully impact the system it takes
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time for the interest rates to truly
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come down and even more once the
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interest rates are down it might take
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time for people to realize that hey
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maybe i want to borrow now and what
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would i use that money for and that for
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that to actually impact the economy
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