2.5 Monetary and fiscal Policy Flashcards
Monetary policy
used by the central bank to influence the quantity of money and credit.
Fiscal policy
relates to the government’s taxation and spending.
Historically, these policies have been used with positive and negative impacts on the economy.
Money fulfills three important functions:
Medium of Exchange
Store of Value
Measure of Value
The quantity theory of money
defines the relationship between money and the price level.
M * V = P * Y
M: is the quantity of money
V: is the velocity of money
P: is the average price level
Y: is the real output:
The price of money is?
The Nominal Interest rate
The Fisher effect
states the real rate of interest is stable
Changes in the nominal interest rate are a function of expected inflation
The Roles of Central Banks
- Supplier of Currency
- Banker to Government and Bankers’ Bank
- Lender of Last Resort
–> his provides needed liquidity to banks in difficult situations.
- Regulator of Payments System
–> Procedures must be robust and standardized to handle the millions of daily financial transactions. International coordination is also necessary.
- Conductor of Monetary Policy
–> This is a high-profile role in which the central bank influences the quantity of money and credit in an economy.
- Supervisor of Banking System
- Maintain Foreign Currency Reserves and Gold Reserves
most important objective of central banks
The most important objective is that of maintaining price stability
Expected inflation
represents the level of future inflation expected by economic agents
Unexpected inflation
the most costly.
It includes the expected inflation cost but also creates a wealth transfer between borrowers and lenders.
Lenders will charge higher interest rates or risk premia to compensate for the extra risk of inflation.
It also reduces the information that can be found in market prices (e.g., price change could be due to inflation or increased demand).
Central banks use three primary monetary policy tools:
- Open Market Operations
–> Open market operations involve the purchase and sale of government bonds from commercial banks. If the central bank buys bonds, this increases the reserves of the private sector banks and thus increases the money supply.
- Central Bank’s Policy Rate
–> The central bank can set the official interest rate. It usually sets the rate it will charge when lending to commercial banks. Increasing the rate will reduce the money supply. The name of the refinancing rate varies by countries, such as the refinancing rate in England and the discount rate in the United States. The federal funds rate is the interbank lending rate in the United States.
- Reserve Requirements
–> The central bank can reduce the money supply by increasing the reserve requirement. This is not used much in developed countries because it is disruptive to the bank’s lending practice.
The success of inflation targeting policy depends on three key concepts:
- Central Bank Independence
- Credibility
–> A government with a lot of debt would be inclined to have high inflation. Credibility would be undermined if the government were in charge of managing inflation. If the public believes the central bank will hit its target inflation, this belief can help it happen.
- Transparency
–> Most central banks produce quarterly reports on the economy.
Central Bank Independence
The central bank needs independence from the government to keep politicians out of the way. However, the central bank still has some accountability to the government.
Target independence gives the bank authority to set the interest rate level target.
Operational independence means the bank can get the target level from another branch of government, but it is otherwise not under the influence of the government.
a currency peg
a fixed exchange rate
managed exchange rate policy
allows the value of the domestic currency to float within a specified range relative to the currency to which it is pegged
For this strategy to be successful, investors must believe that the developing economy is credibly committed to the target exchange rate.
dollarization
Other countries simply abandon their domestic currency and adopt the US dollar as their functional currency