MacroeconomicsI_working_version (1)

Monetary Policy in Details 119
banks, which lend funds from the central bank. These additional funds provided by the
central bank extend credit of commercial banks and enhance the ability to create new
money by the banking system.
Open-market operations
Discount rate
Reserve requirements
Reserves
Money supply
Interest rates
Stable prices
Low unemployment
Sustainable growth in
real GDP
Instruments Intermediate targets Ultimate objectives
Figure 13.1 The central bank uses its instruments to control intermediate targets so that the ultimate
objectives could be reached.
13.2. The Impact of Monetary Policy on Output and Prices
Let’s describe the process of how the changes in money supply affect the ultimate
objectives such as changes in total output, employment, prices and inflation. Such process
is called the transmission mechanism.
13.2.1. Transmission Mechanism: How Money Supply Affects
Total Output
We will describe the process by which the central bank affects output and the price level.
Let’s use a concrete example, when the central bank has decided to slow down the
economic activity because of rising inflation. The process is explained by following five
steps:
1) At the beginning, the central bank takes a restrictive monetary action towards
reducing reserves. The central bank sells government bonds in the open markets to
decrease the amount of reserves hold by commercial banks. It reduces total bank
reserves in banking system.
2) As we explained in chapter 7, a reduction in bank reserves produces a multiple
larger contraction in checkable deposits. Accordingly, a nation’s money supply is
reduced.
3) Reduced money supply implies increased interest rates and tightened credit
conditions.
4) The higher interest rates will lead to a decline in the interest-sensitive spending
especially investment.
5) Finally, a decline in interest-sensitive spending will reduce aggregate demand, and
thus, decrease total output, employment and inflation.