There are two powerful tools our government and the Federal Reserve use to steer our economy in the right direction:
Monetary Policy The government influences investment, employment, output and income through monetary policy. This is done by increasing or decreasing the money supply by the monetary authority.
When the money supply is increased, it is an expansionary monetary policy. This is shown by shifting the LM curve to the right. When the money supply is decreased, it is a contractionary monetary policy. This is shown by shifting the LM curve to the left.
Figure 1 illustrates an expansionary monetary policy with given LM and IS curves. Thus the national income rises from OY to OY1. But the relative effectiveness of monetary policy depends on the shape of the LM curve and the IS curve. Monetary policy is more effective if the LM curve is steeper.
A steeper LM curve means that the demand for money is less interest elastic. The less interest elastic is the demand for money, the larger is the fall in interest rate when the money supply is increased.
The more interest elastic is the demand for money, the smaller is the fall in interest rate when the money supply is increased. A small fall in the interest rate leads to a smaller increase in investment and income.
This shows that monetary policy is less effective in the case of the flatter LM curve and more effective in the case of the steeper curve.
If the LM curve is horizontal, monetary policy is completely ineffective because the demand for money is perfectly interest elastic.
On the other hand, if the LM curve is vertical, monetary policy is highly effective because the demand for money is perfectly interest inelastic. Figure 4 shows that when the vertical LM curve shifts to the right to LM with the Increase in the money supply, the interest rate falls from OR to OR1which has no effect on the demand for money and the entire increase in the money supply has the effect of raising the income level from OY to OY1.
NOW take the slope of the IS curve. With the increase in the money supply, the LM curve shifts to the right to LM1 in Figure 6, the interest rate falls from OR to OR1 but investment being completely interest inelastic, the income remains unchanged at OY.
Figure 7 shows that with the increase in the money supply, the LM curve shifts to LM1. But even with no change in the interest rate OR, there is a large change in income from OY to OY1 This makes monetary policy highly effective.The Monetary Policy is the management of expectations of the economy, supporting the long-term economic growth and employment.
The Monetary Policy is the relationship of interest rates and the economy, the price at which money can be borrowed and the total supply of money. The Monetary Policy . effectiveness of monetary policy, 2) inflation targeting as an “effective monetary policy,” 3) monetary policy and short-run (output) stabilization, and 4) problems in implementing a short-run stabilization policy.
1. Changing Views on the Role and Effectiveness of Monetary Policy. tions of both “monetary policy” and “effective - ness.” Our discussion will address (i) changing views of the role and effectiveness of monetary policy, (ii) inflation targeting as an “effective monetary policy,” (iii) monetary policy and short-run (output) stabilization, and (iv) problems in implementing a short-run stabilization policy.
Editors' Note: The views expressed in this article are those of the author(s) and do not necessarily represent those of the Norges Bank, IMF or their policy. References. Aastveit K A, Natvik G J, and Sola S (), "Economic Uncertainty and the Effectiveness of Monetary Policy", Norges Bank Working Paper N.
. The goals of monetary policy are to promote maximum employment, stable prices and moderate long-term interest rates.
By implementing effective monetary policy, the Fed can maintain stable prices, thereby supporting conditions for long-term economic growth and maximum employment. Monetary policy is a key element of macroeconomic management and its effectiveness is an important issue in economic policy analysis.
To successfully conduct monetary policy, policymakers must have an accurate assessment of .