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Of course, telling the story of the U. The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U. Figure shows how the Federal Reserve has carried out monetary policy by targeting the federal funds interest rate in the last few decades. The graph shows the federal funds interest rate remember, this interest rate is set through open market operations , the unemployment rate , and the inflation rate since Different episodes of monetary policy during this period are indicated in the figure.

Consider Episode 1 in the late s. By , inflation was down to 3. In Episode 2, when economists persuaded the Federal Reserve in the early s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest rate fell from In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6. In Episode 4, in the early s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.

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As the economy expanded, the unemployment rate declined from 7. Inflation did not rise, and the period of economic growth during the s continued. Then in and , the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4. By early , inflation was declining again, but a recession occurred in Between and , the unemployment rate rose from 4.

In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6. They actually did this because of fear of Japan-style deflation. This persuaded them to lower the Fed funds further than they otherwise would have.

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The recession ended, but, unemployment rates were slow to decline in the early s. When the Fed had taken interest rates down to near-zero by December , the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The most powerful and commonly used of the three traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate.

In late , as the U. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing QE. This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand. Quantitative easing differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long term Treasury bonds , rather than short term Treasury bills. In , however, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get.

Read the closing Bring it Home feature for more on this. Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing. This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before.

We usually think of the quantitative easing policies that the Federal Reserve adopted as did other central banks around the world as temporary emergency measures. If these steps are to be temporary, then the Federal Reserve will need to stop making these additional loans and sell off the financial securities it has accumulated.

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The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact. An expansionary or loose monetary policy raises the quantity of money and credit above what it otherwise would have been and reduces interest rates, boosting aggregate demand, and thus countering recession.


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A contractionary monetary policy, also called a tight monetary policy, reduces the quantity of money and credit below what it otherwise would have been and raises interest rates, seeking to hold down inflation. During the — recession, central banks around the world also used quantitative easing to expand the supply of credit.

Contractionary policy reduces the amount of loanable funds in the economy. As with all goods, greater scarcity leads a greater price, so the interest rate, or the price of borrowing money, rises. An increase in the amount of available loanable funds means that there are more people who want to lend.

They, therefore, bid the price of borrowing the interest rate down. How do the expansionary and contractionary monetary policy affect the quantity of money? How do expansionary, tight, contractionary, and loose monetary policy affect aggregate demand?


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  5. Which kind of monetary policy would you expect in response to high inflation: expansionary or contractionary? A well-known economic model called the Phillips Curve discussed in The Keynesian Perspective chapter describes the short run tradeoff typically observed between inflation and unemployment. Based on the discussion of expansionary and contractionary monetary policy, explain why one of these variables usually falls when the other rises.

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    Skip to content Increase Font Size. Monetary Policy and Bank Regulation. Learning Objectives By the end of this section, you will be able to: Contrast expansionary monetary policy and contractionary monetary policy Explain how monetary policy impacts interest rates and aggregate demand Evaluate Federal Reserve decisions over the last forty years Explain the significance of quantitative easing QE. Monetary Policy and Interest Rates. One of NAFTA's many effects was to give American auto manufacturers the incentive to relocate a portion of their manufacturing to Mexico where they could save on the costs of labor.

    The core of most trade agreements is the removal or reduction of tariffs.


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    This evolution of economic systems has increased industrialization and financial opportunities in many nations. Governments now focus on removing barriers to trade and promoting international commerce. Outsourcing by companies brings jobs and technology to developing countries. Trade initiatives increase cross-border trading by removing supply-side and trade-related constraints.

    One clear result of globalization is that an economic downturn in one country can create a domino effect through its trade partners. For example, the financial crisis had a severe impact on Portugal, Ireland, Greece, and Spain. All these countries were members of the European Union, which had to step in to bail out debt-laden nations, which were thereafter known by the acronym PIGS.

    Globalization has become a polarizing issue in the U. It's seen as a major factor in the economic squeeze on the middle class. For better and worse, globalization has also increased homogenization. The sheer size and reach of the U. China and India are among the foremost examples of nations that have benefited from globalization, but there are many smaller players and newer entrants. Indonesia, Cambodia, and Vietnam are among fast-growing global players in Asia.

    Ghana and Ethiopia had the fastest-growing African economies in the world in , according to a World Bank report. Investopedia uses cookies to provide you with a great user experience.

    By using Investopedia, you accept our. Your Money. Personal Finance. Your Practice. Popular Courses. Login Newsletters. Economics Macroeconomics. What Is Globalization? Globalization is a social, cultural, political, and legal phenomenon. Socially, it leads to greater interaction among various populations.