Monetary policy is the action of a central bank, currency board or any other regulatory committee that determines the size & rate of growth of the money supply, which further affects interest rates.
The main instruments to affect interest rates are– Reserve requirements (which affect the demand for reserves & therefore, the demand for central bank money), Lending to banks and Open market operations.
In India, the central monetary authority is the Reserve Bank of India (RBI). It conducts its operations in such a way so as to retain price stability in the economy and attain high economic growth. In the United States, The Federal Reserve is responsible for the monetary policy.
Monetary policy can have two forms- a monetary expansion or monetary contraction. A rise in the money supply is called a monetary expansion, while a fall in the money supply is called a monetary contraction.
A monetary shock is something that results in a shift in the LM curve. This shock could arise from a change in the supply or demand for money. This shock, in turn, can be positive (a rightward shift in LM) or negative(a leftward shift in LM).
Effects of a Monetary Shock in Short, Medium and Long Run: The Adjustment Path
Let’s take the case of a positive monetary shock. The monetary expansion is assumed to be money supply, and the aggregate demand in the economy is represented by the AD curve. The aggregate supply is represented by the AS curve. The aggregate demand and aggregate supply curve intersect at point A, at which the equilibrium output is Yn, which is the natural level of output, and the price level is given by P, which is equal to the expected price level.
Now, the central bank increases the nominal money supply, M, through open market operations (maybe through buying bonds). Given that the price level is fixed, this leads to an increase in the real money supply, M/P.
Recall that, Aggregate demand equation is given by,
Y=Y {M/P, G, T)
where G stands for government spending and T for taxes.
From the above equation, it can be seen that an increase in the real money supply would lead to an increase in output in the short run. The aggregate demand curve shifts from AD to AD’ since there is a change in a factor affecting aggregate demand other than price level. In the short run, the economy moves from point A to A’ along the original AS curve.
Output increases from Yn to Y’ and price level increases from P to P’.
Over time, the adjustment of price expectations comes into play. Aggregate supply curve, which is given by the equation,
P = Pe (1+μ) F (1-Y/L, z)
where Pe is the expected price level, μ is the markup, z is the catchall variable for all other factors that affect wage determination, and in turn, price, L is the labour force, shifts up.
This happens because the output in the short run is more than the natural level of output. The price level is higher than what the wage setters expected. They, therefore, revise their expectations, which causes the aggregate supply curve to shift up over time. The economy moves up the new AD curve, i.e. AD’.
The adjustment process continues till the output returns to the natural level of output. The final equilibrium happens at the intersection of the AS curve represented by AS’’ and the AD’ curve at point A’’, where the output is the same as Yn and the price level is at P’’. P’’ is higher than both P and P’.
The increase in price is to the extent of the increase in nominal money supply. Thus, the real money supply remains constant. The output returns to the natural level of output, and the interest rate to its original level.
Neutrality of Money in the Medium and Long Term
The above discussion shows that in the short run, a positive monetary shock/ monetary expansion leads to an increase in output, a decrease in the interest rate and an increase in the price level. How much of the effect of a positive monetary shock falls initially on output and how much on the price level depends on the slope of the aggregate supply curve.
But over time, the effect of the positive monetary shock/monetary expansion on output and interest rate disappears and but the price level increases further. In the medium run, the increase in nominal money is matched by a proportionate increase in the price level.
Therefore, an increase in nominal money has no effect either on output or on the interest rate. Economists denote to the absence of a medium-run and long-run effect of change of money supply on output & on the interest rate by saying that money is neutral in the medium and long run.
This neutrality of money in no way means that monetary policy cannot or should not be used to affect output. An expansionary monetary policy can help the economy move out of recession & return sooner to the natural level of output. But it is just that a monetary policy cannot withstand higher output forever.
Real Business Cycle Model
The real business cycle model explains business cycles in output and employment as being caused by real shocks. In this model, money is neutral, and level changes in M have no effect on real variables and cause a proportionate increase or decrease in price. This suggests that changes in the LM curve do not explain cycles and that monetary policy is irrelevant. It considers changes in fiscal policy and technology as the real changes which cause the fluctuation in potential output.
Conclusion
The monetary policy is an important instrument in the hand of the central bank of a country to regulate the economy. Through its monetary policy instruments, it can affect the money supply, interest rates, output and price levels in the economy. It can be a saviour in times of recession and can bring the economy out of it. And in the long run, it keeps the output at the natural level of output, the price at the expected price level and the unemployment at the natural rate of unemployment.