Macroeconomics ECON202
Guided notes
Chapter 18 Monetary policy
Big Questions to study
A. What is the effect of monetary policy in the short run?
• In the short run, monetary policy can both speed up and slow down the economy
• Some prices are sticky in the short run. When some prices fail to adjust, changes in the money supply
are essentially a change in real financial resources
• In the short run, expansionary monetary policy can stimulate the economy, increasing real GDP and
reducing the unemployment rate
• In the short run, contractionary monetary policy can slow the economy, which may help to reduce
inflation
B. Why doesn’t monetary policy always work?
• Monetary policy fails to produce real effects under three different circumstances. First, monetary
policy has no real effect in the long run because all prices can adjust. Second, if monetary policy is
fully anticipated, prices adjust. Finally, if the economy is experiencing shifts in aggregate supply,
monetary policy may be unable to restore normal growth, because monetary policy works primarily
through aggregate demand.
1
,C. What is the Phillips curve?
• The Phillips curve is a theoretical negative relationship between inflation and unemployment rates.
The modern consensus is that the Phillips curve is a short-run phenomenon that doesn’t hold in the
long run.The power of inaction to reduce unemployment is directly related to how people’s inflation
expectations adjust throughout the economy. Modern expectations theory allows for adjusting
expectations, which is why most economists now believe that the Phillips curve relationships doesn’t
hold in the long run.
Flow of chapter 18
The effect of monetary policy in short run
- Expansionary monetary policy
- Contractionary monetary policy
A. What is the effect of monetary policy in the short run?
Two kinds of monetary policy
- Expansionary monetary policy
- Contractionary monetary policy
• When economic growth stagnates and unemployment rises —> we look to the central bank to help the
economy
2
, • Central banks in most countries use monetary policy to reduce interest rates which generates
new economic activity
• The U.S. Federal Reserve generally uses open market operations to implement monetary policy
(increasing or decreasing the money supply)
• Recall the difference between the short run and the long run in macroeconomics:
• The long run is a period of time long enough for all prices to adjust
• In the short run —> some prices, often the prices of resources such as wages for workers and
interest rates for loans, are inflexible
A1. An Overview of Monetary Policy in the Short Run
• Ex: you have a college apparel business —> suppose you already have one retail location where you
sell apparel, and your re now considering opening a second
• Before you can open a new store, you need to invest in several resources such as physical
location, additional inventory, and some labor
• You expect the new store to earn the revenue needed to pay for these resources eventually
• But —> you need a loan to expand the business now, so you go to the bank
• The bank is willing to grant you a loan, but the interest rate is higher than your
expected return on the investment —> you decide not to open a new location
• Then —> the central bank decides to expand the money supply
3
, • It buys Treasury Securities from banks —> which increase the level of
reserves in the banking system
• As a result —> interest rates fall at your local bank
• You then take out a loan, open the second apparel shop, and hire
a few employees
• In this example —> monetary policy affects your actions and your actions affect the
macroeconomy
• First —> investment increases because you spend on equipment, inventory, and a physical
location
• Second —> aggregate demand increases because your investment demand is part of
overall aggregate demand
• Finally —> as a result of the increase in aggregate demand, real GDP increases and
unemployment falls as your output rises and you hire workers
• This is what increasing the money supply can do in the short run —> it expands the
amount of credit (loanable funds) available and paces the way for economic
expansion
• Concepts from previous chapters to remember throughout this chapter as we put them together:
• (1) The Fed uses open market operations to implement monetary policy. Open market operations
involve the purchase or sale of bonds; normally these are short-term Treasury securities.
4
Guided notes
Chapter 18 Monetary policy
Big Questions to study
A. What is the effect of monetary policy in the short run?
• In the short run, monetary policy can both speed up and slow down the economy
• Some prices are sticky in the short run. When some prices fail to adjust, changes in the money supply
are essentially a change in real financial resources
• In the short run, expansionary monetary policy can stimulate the economy, increasing real GDP and
reducing the unemployment rate
• In the short run, contractionary monetary policy can slow the economy, which may help to reduce
inflation
B. Why doesn’t monetary policy always work?
• Monetary policy fails to produce real effects under three different circumstances. First, monetary
policy has no real effect in the long run because all prices can adjust. Second, if monetary policy is
fully anticipated, prices adjust. Finally, if the economy is experiencing shifts in aggregate supply,
monetary policy may be unable to restore normal growth, because monetary policy works primarily
through aggregate demand.
1
,C. What is the Phillips curve?
• The Phillips curve is a theoretical negative relationship between inflation and unemployment rates.
The modern consensus is that the Phillips curve is a short-run phenomenon that doesn’t hold in the
long run.The power of inaction to reduce unemployment is directly related to how people’s inflation
expectations adjust throughout the economy. Modern expectations theory allows for adjusting
expectations, which is why most economists now believe that the Phillips curve relationships doesn’t
hold in the long run.
Flow of chapter 18
The effect of monetary policy in short run
- Expansionary monetary policy
- Contractionary monetary policy
A. What is the effect of monetary policy in the short run?
Two kinds of monetary policy
- Expansionary monetary policy
- Contractionary monetary policy
• When economic growth stagnates and unemployment rises —> we look to the central bank to help the
economy
2
, • Central banks in most countries use monetary policy to reduce interest rates which generates
new economic activity
• The U.S. Federal Reserve generally uses open market operations to implement monetary policy
(increasing or decreasing the money supply)
• Recall the difference between the short run and the long run in macroeconomics:
• The long run is a period of time long enough for all prices to adjust
• In the short run —> some prices, often the prices of resources such as wages for workers and
interest rates for loans, are inflexible
A1. An Overview of Monetary Policy in the Short Run
• Ex: you have a college apparel business —> suppose you already have one retail location where you
sell apparel, and your re now considering opening a second
• Before you can open a new store, you need to invest in several resources such as physical
location, additional inventory, and some labor
• You expect the new store to earn the revenue needed to pay for these resources eventually
• But —> you need a loan to expand the business now, so you go to the bank
• The bank is willing to grant you a loan, but the interest rate is higher than your
expected return on the investment —> you decide not to open a new location
• Then —> the central bank decides to expand the money supply
3
, • It buys Treasury Securities from banks —> which increase the level of
reserves in the banking system
• As a result —> interest rates fall at your local bank
• You then take out a loan, open the second apparel shop, and hire
a few employees
• In this example —> monetary policy affects your actions and your actions affect the
macroeconomy
• First —> investment increases because you spend on equipment, inventory, and a physical
location
• Second —> aggregate demand increases because your investment demand is part of
overall aggregate demand
• Finally —> as a result of the increase in aggregate demand, real GDP increases and
unemployment falls as your output rises and you hire workers
• This is what increasing the money supply can do in the short run —> it expands the
amount of credit (loanable funds) available and paces the way for economic
expansion
• Concepts from previous chapters to remember throughout this chapter as we put them together:
• (1) The Fed uses open market operations to implement monetary policy. Open market operations
involve the purchase or sale of bonds; normally these are short-term Treasury securities.
4
