>> We think that given enough
time for prices and wages

to adjust output gaps will
eventually correct themselves.

But many economists
say why wait.

One way for policy makers
to intervene in the economy

and push output back
to potential is

through monetary policy.

In the United States
monetary policy is conducted

by the Federal Reserve
or the Fed.

The most common way the Fed
implements monetary policy is

through open market operations,

which basically means
buying and selling bonds.

Suppose the economy has fallen
into a recessionary gap.

The federal implement
Expansionary Monetary Policy;

the Federal Open Market
Committee will buy bonds,

typically U.S. treasury
bonds from banks.

This takes bonds
out of circulation

and puts more cash
into circulation.

When the Fed buys a huge
number of bonds it drives

up the price of bonds.

Since interest rates move
in the opposite direction

of bond prices interest
rates fall.

Lower interest rates stimulate
spending in the economy.

Lower interest rates make it
easier for consumers to borrow

for homes cars and
other big ticket items

and make it more profitable for
businesses to invest in capital

like factories, delivery
trucks, and computers.

That additional spending
boosts aggregate demand,

raising output back
to potential.

The Fed has taken this
kind of action many times;

during the early
1990s recession,

during the dot com recession,
and during the financial crisis

of 2008 the Federal
Reserve bought bonds

to lower interest rates
and stimulate production.

Likewise, suppose the economy
enters an inflationary gap;

the Fed will implement
Contractionary Monetary Policy.

The Federal Open Market
Committee will sell bonds

to banks; this takes
cash out of circulation.

When the Fed sells a huge
number of bonds it drives

down the price of bonds.

Since interest rates move
in the opposite direction

of bond prices interest
rates rise.

Higher interest rates reduce
spending in the economy.

They make it harder for
consumers to borrow for homes,

cars, and other big
ticket items,

and they make it less profitable
for businesses to invest

in capital like factories,
delivery trucks, and computers.

That reduced spending
decreases aggregate demand,

lowering output back
to potential.

The Federal Reserve did
this in a dramatic way

in the early 1980s

when inflation was
rising out of control.

The Fed sold a huge
number of bonds,

driving interest
rates up dramatically.

Aggregate demand fell; in fact
it fell so far that we went

from an inflationary gap
to a recessionary gap,

but prices stabilized,
inflation expectations fell,

and the economy eventually
recovered with low inflation.

So monetary policy is how the
Federal Reserve changes the

money supply to boost
or reign in the economy.

Expansionary Monetary Policy
increases the money supply,

reduces interest rates,

and raises output while
Contractionary Monetary Policy

cuts the money supply,
increases interest rates

and reduces output.