The monetary policy & neutrality

Sara Vogel

7, April 2014

Econ 122

Dr. Kassens

            In Principles of macroeconomics, N. Gregory Mankiw discusses the concept of money growth and inflation. The Federal Reserve uses the monetary policy to control the U.S. economy. This policy helps determine the money supply by figuring out the amount of money to print and it’s growth rate. In the 18^th century, David Hume and his partners thought that economic variables should be categorized into two groups, “nominal variables and real variables” (Mankiw, 2012, p. 353). To distinguish the two, “nominal variables are measured in dollars and real variables measure by the economy’s output of goods and services” (Mankiw, 2012, p. 353). A few examples of real values would be real wages and real GDP and nominal variables are nominal wage rate or nominal GDP. The two categories that separate them is called classical dichotomy. Classical dichotomy is important because many things can affect real and nominal variables. One example is money being factored in; in the long run this affects nominal variables because it measures in dollars. For real variables it does nothing, because money is not as important when measuring physical units. Money is neutral when real variables (real GDP or real wages) do not change because of the increase of money supply.

            Monetary policy is important because the central banks (Fed) are here to balance and maintain a healthy economy. Of course there are problems that occur like inflation and hyperinflation. To prevent these problems the Fed can change the amounts of reserves it has. They could use the open-market operations, “the purchase and sale of U.S. government bonds by the Fed” (Mankiw, 2012, p. 337). To increase the money supply the trade from buying bonds would come from the public nation’s bond markets. The trade would increase the money flow in the economy either as currency or in the bank. To reduce the money supply they “can sell the government bonds to the public” (Mankiw, 2012, p. 337). The money the public uses to buy these bonds will decrease the amount of money that is circulating. Another way to increase reserves is when the “banks feel that they don’t have enough money to lend out, so they end up asking the Fed for loans” (Mankiw, 2012, p. 337). These loans have discount rates that have interest that the banks must pay when borrowing money from the Fed. When the bank receives these loans they will end up having extra reserves to help create additional money. The money supply will be adjusted based on the interest rate the Fed decides on. When the discount rate is high, banks will not want to ask for loans. This will decrease the amount of reserves the bank will have, which will also decrease the money supply. It is the opposite for a low discount rate.

            Overall having a monetary policy is important in having a good economy. The Fed keeps a close eye on the changes that occur in the money supply so that they can find solutions to bring back a healthy, stable economy that a country pictures.   

Works Cited

Mankiw, N. G. (2012). Money growth and inflation. In N. G. Mankiw (Author), Principles of     macroeconomics (6th ed., pp. 347-371). Mason, OH/USA: South-Western Cengage Learning.