2.5 Monetary Policy Flashcards
What is monetary policy?
Refers to the governments use of interest rates and the money supply to influence the level of AD and economic activity.
What are interest rates?
Refer to the price of borrowing money or the return from saving money at financial institutions.
What is the money supply?
Refers to the entire quantity of money circulating an economy.
Why is direct control of the money supply relatively difficult?
The definition of money is quite loose and banks can create credit fairly easily. Hence most governments rely on interest rate policy to achieve economic stability.
What is the price and quantity of money called?
The price of money is called the interest rate, the quantity of money is called the money supply. The equilibrium interest rate is determined by the intersection of the demand for and supply of money.
What does the demand for money refer to?
The desire to hold money rather than saving it to finance consumption and current expenditure. Interest rtes tend to rise when the quantity of money demanded exceeds the quantity supplied.
What does the supply of money refer to?
The total amount of money circulating in the economy at any point in time. An increase in the money supply will tend to decrease interest rates.
Why does the opportunity cost vary directly with the level of interest rates?
A fall in interest rates will reduce the opportunity cost of holding money.
What are the factored the central bank will consider when setting interest rates?
State of the economy - eg deflationary gap may require a reduction in interest rates to prevent economy from deep recession
The rate of growth of nominal wages - higher costs of labour usually mean that firms will increase prices, higher interest rates might then be used to combat inflationary pressure.
Business confidence levels - lower interest rats tend to create incentives for investment expenditure due to lower costs and hence risks of investment.
House prices - may have a direct impact on level of consumer confidence and hence the value of consumption and potential economic growth in the economy.
The exchange rate - lower interest rates might be needed to reduce demand for currency on forge in exchange market.
What is a central bank?
Monetary authority of a country that oversees the entire banking system by managing the money supply the nations currency and interest rates.
How do the central bank act as the executor of monetary policy?
Responsible for managing interest rates and the exchange rate for its currency in order to achieve macroeconomic objectives.
How do the central bank act as the governments bank?
Responsible for the money of the government including its foreign currency reserves. Maintaining the accounts d the government in the same way that commercial banks maintain the accounts of their customers.
How do the central bank act as the bankers bank?
Regulator of country commercial banking system. Commercial banks must keep a certain percentage of their cash reserves at the central bank so that it can control the money supply and use these reserves in times of financial emergency.
How do the central bank act as the sole issuer of legal tender?
As the supreme banks the central banks is the sole issuer of bank notes and coins within the country. This helps to control the money supply and bring uniformity and confidence to the monetary system.
How do the central bank act as the lender of last resort?
Central bank provides loans to commercial banks when necessary to prevent risks of financial crisis cause by limited cash reserves and liquidity problems. This function help to ensure that the banking system runs smoothly.
