3.5 Demand Side Policy - Monetary Policy Flashcards
What is monetary policy
Changes in interest rates and money supply to influence aggregate demand in an economy
Goals of monetary policy
Low and stable rate of inflation
Low unemployment
Reduce business cycle fluctuations
Promote a stable economic environment for long term growth
What is interest
Payment for a loan ; the costs of borrowing
How does the supply of money influence interest rates + show the graph
Increase in supply of money leads to a fall in interest rate and vice versa
How does the central bank change the money supply
When banks make loans they create new money
The lower the minimum reserve requirement, the greater the excess reserves, the more loans can be made by commercial banks, and the more new money can be created
What are required reserves
Funds which must be legally kept
Tools for monetary policy
Open market operations
Minimum reserve requirements
Central bank minimum lending rate
Quantitative easing
Explain open market operations
If central bank wishes to lower interest rates then they must increase money supply which id done through:
- central bank buying bonds from commercial banks, paying the commercial banks for them
- this increase commercial banks excess reserves, which can be used to make more loans
- increasing the money supply, giving rise to lower interest rates
Explain minimum reserve requirements
Changes of the minimum reserve requirements by the central bank
If reserve requirements decrease, means commercial banks excess reserve increase, their lending ability increases and their ability to create money, money supply increases
Explain central bank minimum lending rate
Minimum lending rate is charging interest rates to commercial banks when lending
Process:
- If central bank decreases the interest rates to lend
- becomes less costly from commercial banks to borrow
- increasing their reserves
- increasing the money supply
Explain quantitative easing
Central banks purchase large amounts of bonds and assets that commercial banks have or own
In order to pay for assets the central bank creates reserves electronically for commercial banks
The commercial banks sell the assets end up with more reserves, used to make more loans, increasing the money supply and stimulating the economy
What is real interest rates
Interest rates that have been corrected from inflation
Equation for real interest rates
Nominal interest rate - rate of inflation
Monetary policy to fix to close deflationary gaps + the graph
Expansionary monetary policy:
- drop in interest rates, lower cost of browning
- consumers + firms more likely to borrow + spend
- increase to AD , rightward shift of AD, closing deflationary gap
Monetary policy to correct inflationary gap
Contractionary monetary policy:
- reduces monetary policy, resulting in increase interest
- higher cost of borrowing, reducing borrowing by firms + consumers
- lower investment spending + consumer spending
- decrease in AD, leftward shift of AD, closing inflationary gap
2 types of monetary policy
Contractionary and expansionary monetary polciy
What is expansionary monetary policy
The increase in money supply and decrease in interest rates in order to stimulate an economy and increase AD
What is contractionary monetary policy
The decrease in money supply and increase in interest rates in order to decrease AD
What are constraints of monetary policy
Conflict between government objectives - changes in interest rates also affect foreign sector such as exchange rates - pursuit of domestic objectives may conflict with pursuit of external balance in the foreign sector
Possible ineficientes in recession due to:
- interest rates cannot fall when approaching zero - as IR approach zero, cannot fall further
- low consumer and producer confidence - if stakeholders are pessimistic about future, may avoid taking out new loans and spending, so AD will not increase
- banks may be fearful of lending - in severe recession, banks fear borrowers may not repay loans, reducing lending
What are strengths of monetary policy
Interest rates can be incremental - IR can be adjusted in small steps, beneficial for fine tuning of economy
Interest rates are reversible - IR can be reversed if necessary, e.x expansionary MR can be reversed into contractionary MR
Monetary policy is flexible - IR can be changed often according to needs
Monetary policy have short time lags - can be implemented relatively quickly, is subject to time lags as it takes time for IR to affect economy, but shorter time lags then fiscal
Limited political constraints - does not face any political pressure as fiscal policy
