24 - Monetary policy

Question 1

Monetary policy

Answer 1

Use of interest rates and control of money supply by the central bank to influence the level of aggregate demand and economic activity.

Question 2

interest rates

Answer 2

the price of money. expresses as a percentage measure, interest rates represent the cost of borrowing money or the return for savers

Question 3

money supply

Answer 3

the amount of money in circulation within the economy at a particular point in time, as determined by the central bank.

Question 4

The process of money creation by commercial banks

Answer 4

Credit creation - refers to the process by which commercial banks create money from deposits from savers, and use these funds as loans to borrowers

Question 5

Minimum reserve ratio (MRR)

Answer 5

Minimum reserve ratio (MRR) - the lowest amount that commercial banks are required to keep as reserves in the central bank, thereby limiting how much they can lend and how much credit they can create

Question 6

Tools of monetary policy

Answer 6

• Open market operations (OMO)
• Minimum reserve requirements
• Changes in the central bank minimum lending rate
• Quantitative easing

Question 7

Open market operations (OMO)

Answer 7

Open market operations refer to the buying and selling of government securities by a country’s central bank
- OMO as contractionary monetary policy: When the central bank wants or needs the money supply to fall, in order to slow inflation and/or stabilize economic growth, it can sell government securities to banks or other investors. The higher interest rate (the return paid to purchases of the securities) attracts buyers or investors. It withdraws money from the economy as buyers of the government securities don’t spend this money on consumption or investment. → higher interest rates, more savings
- OMO as expansionary monetary policy: **When the central bank want to increase the money supply to lower the price of money (or the interest rate) to stimulate higher aggregate demand in the economy, it will do this by purchasing government securities (from government). This injects money into the economy, thereby helping to lower unemployment and encourage econoimc growth (government spend the money earned from central bank purchasing government securities). → lower interest rates, more spending and investment

Question 8

Minimum lending rate

Answer 8

Minimum lending rate (MLR) - the official rate of interest charged by the central bank on loans to commercial banks. The central bank will not lend money below its rate.
- MLR as contractionary monetary policy - The central bank or government can raise the MLR, which tends to cause commercial banks and other financial institutions to also increase their lending rates. Hence, the higher lending rates mean that households and firms are likely to be discouraged from borrowing money while the higher interest rates can encourage people to save more. → reducing consumption (C) and investment (I)
- MLR as expansionary monetary policy - The central bank or government can lower the minimum lending rate, making commercial banks and other financial institutions to lower their lending rates as well. This will encourage consumers and firms to borrow more money to consume and invest rather than saving. → increasing consumption (C) and investment (I)

Question 9

Quantitative easing (QE)

Answer 9

an expansionary monetary policy tool that injects money directly into the economy via the central bank purchasing corporate bonds (e.g. commercial banks, insurance companies).

Question 10

nominal interest rate

Answer 10

the actual rate that is agreed between a bank and the customer, that is, it is the rate borrowers pay on their loans or the return savers receive on their cash deposits.

Question 11

real interest

Answer 11

real interest accounts for the impact of inflation on the return to savers and the cost of debts to borrowers

Question 12

negative interest rates

Answer 12

negative real interest rates occur when the inflation rate is greater than the nominal interest rate, meaning any return on savings are completely diminished by the effects of higher prices in the economy

Question 13

Constraints of MP

Answer 13

• Limited scope of reducing interest rates, when close to zero
• Low consumer and business confidence

Question 14

Strengths of MP

Answer 14

• Incremental, flexible and easily reversible
• Short time lags

Question 15

Expansionary monetary policy

Answer 15

A demand side policy used to boost econoimc activity by expanding the money supply. This is achived mainly by lowering interest rates, to stimulate aggregate demand, thereby closing a deflaitonary gap.
- reduced interest rates → makes borrowing for consumption (C) and investment (I) more attractice due to lower interest repayments

Question 16

Contractionary monetary policy

Answer 16

A demand side policy used to reduce the level of economic activity by restricting the money supply. This is achived mainly by higher interest rates to limit aggregate demand, thereby closing an inflationary gap.
- increase in interest rates → reduced consumption (C) and investment (I) in the economy