Monetary Policy Analysis

Monetary Policy Analysis

ECO/533 Economics for Managerial Decision Making

December 1, 2004

Monetary Policy Analysis

This paper will look at the Federal Government's monetary policy, and evaluate the impact of monetary policy using a framework of aggregate demand. It will also examine the role of the Federal Reserve in implementing monetary policy and it impact on economic growth. The basis of this analysis is taken from McConnell and Brue (2001) "Economics - Principles, Problems and Policies, 15th Edition" and Arnold (2001) "Economics Fifth Edition." References cited and used are at the end of the paper in the references section.

McConnell and Brue (2001) indicated that macroeconomics often uses the aggregate demand (AD) and aggregate supply (AS) framework of analysis to discuss the price level, GDP, Real GDP, unemployment, interest rates, discount rate and economic growth (Chap. 13 - 15).

Collins and Devanna (1994) stated, "Monetary policy refers to the government's control of the nominal stock of money, fiscal policy to its control over government expenditure and taxation" (p. 115).

1. Evaluate the impact of monetary policy using a framework of aggregate demand.

When evaluating the impact of the monetary policy using the framework of AD, McConnell and Brue (2001) stated that the monetary policy of the Federal Reserve is the deliberate change in the interest rate, discount rate to control the supply of money and level of spending in the economy. The also indicated, "The goal is to achieve and maintain price-level stability, full employment, and economic growth" (p. 282).

As we discussed last week in class, several components make up the GDP. They are C = Consumption, I = Investment, G= Government purchases, NX = Net exports, EX = Exports, and IM = Imports. If there are changes in spending in these various components, it has a definite impact on the changes in AD. For example, if C, G, NX, and I increase, then AD will also increase. If C, G, NX, and I decrease, then AD will also decrease (Arnold, 2001, p. 165). .

Collins and Devanna (1994) provided a figure that showed the concept that when AD shifts down from AD0 to AD1 and the price level is stuck at P0, that by use of the tools available to the Federal Reserve and use of the monetary policies, that the government can shift AD back to AD0 thus restoring full employment. They also indicated that when AD is located at AD1 and the price level is P0 that there "is insufficient demand to keep the economy's resources fully employed." They mentioned that government could increase its "expenditures on highways, education, national defense, and other items." Another method could be lowering taxes, thus increasing disposable income. The last method that Collins and Devanna (1994) discussed was to increase the "nominal money supply" (p. 115).

2. Examine the role of the Federal Reserve, in implementing monetary policy and its impact on economic growth.

In examining the role of the Federal Reserve, Arnold (2001) indicated that the Federal Reserve is a central bank; essentially, it is a bank's bank. The central bank consists of 12 banks whose policies are coordinated by the Federal Board of Governors. Its role is to control the United States supply of money (p. 295).

McConnell and Brue (2001) stated, there is a policy making group within the Fed called the "Federal Open Market Committee (FOMC)." The FOMC sets the "Fed's monetary policy and directs the purchase and sale of government securities (bills, notes, and bonds) in the open market" (p. 255). It allows a more precise and rapid control of the money supply than any of the other monetary policy tools (p. 255).

When the FOMC buys government securities in the open market, the money supply goes up. Arnold (2001) used the example, "Consider the case of