Evaluating the Effectiveness of Monetary Policy During Recessions

Monetary Policy is often employed during recessions to try and stimulate aggregate demand by reducing interest rates in the banking system. The effectiveness of these policies, however, depends on just how responsive the private sector is to decreases in the interest rate initiated by the central bank.

During mild recessions, when Investment demand is still relatively strong and businesses will respond to lower interest rates by demanding more funds for capital investments, expansionary monetary policy can be relatively effective at stimulating aggregate demand and moving the economy back towards its full employment level of output. However, if a country is in a deep recession, then investment demand will be weak and businesses will be relatively unresponsive to lower interest rates, as low confidence and the expectation of future deflation creates a strong incentive to save, rather than invest.

This lesson will use the money market diagram and the investment demand curve in the loanable funds market to evaluate the effectiveness of monetary policy during recessions. Based on this evaluation, we can better understand the circumstances under which expansionary fiscal policy may be justified, despite its effect on deficits and debt.

Introduction to Supply-side Policies

This lesson will introduce some of the market-oriented and interventionist supply-side macroeconomic policies a government may implement to promote the accomplishment of objectives such as full employment, economic growth and price level stability.
Supply side policies contrast with demand-side fiscal and monetary policies, which are aimed at stimulating or contracting the level of spending in an economy. Supply-side policies, on the other hand, are meant to stimulate production among the nation’s firms by either reducing the costs faced by firms through deregulation and labor market reforms or by improving the productivity of the human and physical capital available to producers. If successful, supply-side policies will stimulate job creation and economic growth, allowing output and employment to increase while maintaining a stable price level in the economy.

Money Creation in a Fractional Reserve Banking System

In this video we illustrate the process by which money is created in a fractional reserve banking system. Due to the fact that at any given time a bank must only keep a certain percentage of its total deposits on reserve, an initial deposit of a certain amount of money will be multiplied as the bank loans out any excess reserves, whose spending leads to further new deposits and even further loans in the economy.

Through this process money is actually multiplied and created. This gives monetary policy makers the ability to stimulate or contract the overall level of spending in an economy through its buying and selling of government bonds from the private sector on the open market.


The Tools of Monetary Policy

This video lesson graphically presents the three tools Central Banks have at their disposal for managing the level of aggregate demand in the economy. Through increasing or decreasing the money supply, a central bank has influence over the interest rates in a nation, and therefore over the level of investment and consumption among firms and households. To accomplish this, three tools are employed: The reserve requirement, the open market purchase or sale of government bonds, and the discount rate.

This lesson illustrates these three tools and explains the relative importance of each to monetary policy makers.

After watching this video, consider reading and responding to the discussion questions for the following blog posts:


Introduction to the Money Market

Macroeconomics policymakers have two general tools in their kit to manage the level of aggregate demand in an economy. The first is fiscal policy, which involves government changing the levels of taxes and government spending to manage demand. Central banks engage in the second type of demand-management, known as monetary policy. By changing the supply of money available in a nation, central banks can raise and lower interest rates and thereby stimulate or contract the level of aggregate demand in the nation.

This video lesson introduces the money market, a model essential to understanding the workings of monetary policy. The supply and demand for money are introduced, and the basic effect of monetary policies are modeled in the simple money market diagram. In later videos, the various tools available to monetary policy makers will be explained and evaluated using the money market model.

After watching this video, consider reading and responding to the discussion questions for the following blog posts: