Systems Thinking Through: Monetary Policy
Monetary policy is one of the ways the economy maintains stability.
This one was tedious since many elements could be considered parts of other elements. Example Interest Rates going down means consumer spending goes up, and so does aggregate demand, but consumer spending is part of aggregate demand so I have the choice of being thorough and redundant or oversimplifying. For a basic intro simple is better.
We’ll go left to right starting with Expansionary Monetary Policy. To stimulate an economy the central bank will use expansionary monetary policy to increase the money supply. Higher money supply means lower interest rates. Lower interest rates mean higher aggregate demand. Higher aggregate demand means more growth, but it can also lead to Demand Pull inflation. Inflation can also increase if the money supply is expanded too much for too long. If inflation starts to get too high the fed will engage in Contractionary Monetary Policy reducing the money supply and raising interest rates again and so on.
Expansionary and Contractionary Monetary Policy could be combined into one element labeled “Fed ownership of bonds.” The more government bonds the federal reserve owns the higher the money supply is. When the fed owns a small number of bonds the money supply is low.
Open Market Operations (buying and selling of government securities by the FED) are the most common way to manipulate the money supply. In this map those are covered under Private bond holdings.
If bonds are increasingly in private hands it means the Fed has sold bonds and the money supply will be going down. When the money supply goes down, money is scarce, interest rates go up.
The Fed can also raise Reserve Requirements (Required amount banks must have on hand for withdrawals.) When required to hold more, banks must loan less reducing the money supply and raising interest rates.
Finally the Fed can raise the Discount Rate (Rate at which loans are lent by the fed to banks on a short term basis. Higher discount rates mean it’s more expensive for banks to borrow money. Banks will loan less, money supply goes down, which means interest rates go up.
