Monetary policy is the use of the money supply to influence interest rates and manage the economy. The money supply in the United States is regulated by the Federal Reserve through open market transactions, the discount rate, and the reserve ratio. The Federal Reserve has 'operational independence' of the government and can set targets for inflation, the money supply, and interest rates at the level most appropriate to achieve those targets. A majority decision of the Board of Directors is all that is required to change the money supply and thus the level of interest rates.

Monetary policy may be used either to inflate the economy or to deflate the economy.

If the Fed considers that there is a danger of a recession, then they may consider increasing the money supply. Buying bonds, lowering the discount rate, and cutting the reserve ratio are all part of a loose money policy which will allow banks to lower interest rates will encourage people (and firms) to borrow more money. It will also give people who have mortgages more money to spend each month as their mortgage payments fall. The combination of these effects will increase the levels of consumption and investment. Since consumption and investment are two of the key components of aggregate demand, cutting interest rates should result in increased aggregate demand and reduced unemployment as well as move money into investment which will encourage long run economic growth and a shift of aggregate supply as well.

Loose money policies are therefore:

• Buying bonds on the open market by raising the price of bonds
• Cutting the discount rate
• Lowering the reserve ratio

Why not try this on your Virtual Economy?  You do not have direct control over the money supply in the Virtual Economy, but you can cut  interest rates. See what effect this has on economic growth and unemployment. Economic growth should end up higher than previously forecast, and unemployment lower. But what happens to inflation? What would you expect?

If the Fed thinks that inflation is in danger of rising and perhaps going over their inflation target, then they may consider decreasing the money supply with a tight money policy. Decreasing the money supply through the sale of bonds in the open market, raising the discount rate, and raising the reserve requirement should increase interest rates and discourage people (and firms) from borrowing money. It will also give people who have mortgages less money to spend each month as their mortgage payments rise. The combination of these effects will reduce the levels of consumption and investment. Since consumption and investment are two of the key components of aggregate demand, increasing interest rates should result in reduced economic growth and increased unemployment.

Tight money policies are therefore:

• Selling bonds on the open market by lowering the price of bonds
• Raising the discount rate
• Raising the reserve ratio

Why not try this on the Virtual Economy?  You do not have direct control over the money supply in the Virtual Economy, but you can try increasing interest rates. See what effect this has on economic growth and unemployment. Economic growth should end up lower than previously forecast, and unemployment higher. But what happens to inflation? What would you expect?

Many economists argue that any discretionary changes in the money supply will have an adverse impact on inflation and the economy. Strict Monetarists and classical economists use the Quantity Theory of Money and the idea of  Rational Expectations to back up their argument that excess money supply growth will feed inflation, and thus advocate a Monetary Rule that the money supply should only be increased by the exact amount of growth every year in order to keep inflation stable and predictable.

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