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This would be a good opportunity to point out one very important fact. We associate monetary policy with lower or higher interest rates, but what most people do not realize is that what the Fed is actually doing is changing money supply (and not interest rates directly). When money supply changes, interest rates automatically adjust to keep the money market in equilibrium.
The 3 tools of monetary policy (the discount rate, the required reserve ratio, and open market operations) all work by changing money supply. However, it would not make any sense to any one if the Fed were to announce that it was increasing money supply by say $30 billion. What makes more sense is to announce the resulting decrease in interest rates, since people relate more to a change in interest rates and do not really understand the money supply change that brought it about.
However, as students of economics we must always keep in mind the fact that the first target of monetary policy is money supply. The Fed can change money supply by the amount desired to bring about the change in interest rates that it wants.
so monetary policy tools --> money supply change --> interest rate change.
Make sense?
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Solution Summary
This solution addresses the following discussion:
This would be a good opportunity to point out one very important fact. We associate monetary policy with lower or higher interest rates, but what most people do not realize is that what the Fed is actually doing is changing money supply (and not interest rates directly). When money supply changes, interest rates automatically adjust to keep the money market in equilibrium.
The 3 tools of monetary policy (the discount rate, the required reserve ratio, and open market operations) all work by changing money supply. However, it would not make any sense to any one if the Fed were to announce that it was increasing money supply by say $30 billion. What makes more sense is to announce the resulting decrease in interest rates, since people relate more to a change in interest rates and do not really understand the money supply change that brought it about.
However, as students of economics we must always keep in mind the fact that the first target of monetary policy is money supply. The Fed can change money supply by the amount desired to bring about the change in interest rates that it wants.
so monetary policy tools --> money supply change --> interest rate change.
Make sense?
Solution Preview
Exactly -- we use the monetary policy tools to change the money supply, which then affects the interest rates. When the money supply is increased through monetary policy tools, it lowers interest rates, which increases demand for investment. Due to the lower interest rates, people go out and put their ...
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