3.5 - Government Management of the Economy - Monetary Policy

Question 1

Define Monetary Policy.

Answer 1

A demand-side policy where the central bank uses changes in the money supply or interest rates to affect AD.

Question 2

What are the four methods for the central bank to apply monetary policy?

Answer 2

• Base interest rates
• Quantitative easing
• Open market operations
• Minimum reserve requirements

Question 3

What are the four aims of monetary policy?

Answer 3

• Sustainable economic growth
• Low unemployment
• External balance on the current account balance of payment
• Low inflation or price stability

Question 4

Define base interest rate.

Answer 4

The interest rate that the central banks charge commercial banks for short term loans.

Question 5

Define market interest rates.

Answer 5

The other important influence on interest rates in the economy is the interest rates set in the money markets. The market rate of interest is determined by the demand and supply of money.

Question 6

Draw a demand for money diagram.

Answer 6

Question 7

Explain the demand for money.

Answer 7

Firms and households demand money because they need to make transactions when they buy goods and services.

There is a negative relationship between the rate of interest and the demand for money.

Question 8

Explain the supply of money.

Answer 8

The supply of money in the economy is set by the central bank and the banking system.

The supply of money is fixed in a given time period and is perfectly inelastic.

Question 9

What is the equilibrium interest rate?

Answer 9

Where the demand for money equals the supply of money.

Question 10

Draw a diagram showing an increase in the interest rate due to a shift in the demand for money.

Answer 10

Question 11

Define nominal interest rate.

Answer 11

Nominal interest rate does not take inflation into account.

Question 12

Define real interest rate.

Answer 12

The real interest rate takes inflation into account.

Nominal interest rate - inflation rate = real interest rate

Question 13

Define expansionary monetary policy.

Answer 13

An expansion of the money supply through reduced interest rates and / or quantitative easing.

This is used to stimulate the economy by reducing the cost of borrowing, which in turn encourages private consumption and investment.

Question 14

Outline the steps of expansionary monetary policy.

Answer 14

• The central banks reduces the base interest rate.
• Commercial banks pass on this reduction to households and firms through lower-interest loans.
• Firms and households receive less interest on the funds they hold in banks.
• Higher borrowing and lower saving rates increase consumption and spending.
• As consumption and investment rise, aggregate demand increases .
• Increased aggregate demand would lead to higher GDP, economic growth and a fall in unemployment.

Question 15

Draw a diagram that represents the rise in aggregate demand closing the deflationary gap.

Answer 15

Question 16

List the strengths of expansionary monetary policy.

Answer 16

• Expansionary monetary policy is relatively quick to apply.
• Monetary policy can be applied incrementally.
• Not subject to political influence

Question 17

List the weaknesses of expansionary monetary policy.

Answer 17

• It can lead to a rise in the average price and an increase in inflation.
• When interest rates are already low, central banks have little room to reduce rates.
• Commercial banks may not pass on the decrease.
• If there are low levels of business and consumer confidence it may mean firms and households do not increase consumption and investment.
• Time lags in the application of monetary policy which can lead to policy errors.
• Can lead to a depreciation in the exchange rate.

Question 18

Define contractionary monetary policy.

Answer 18

Contractionary monetary policy is where the government through the central bank increases interest rates and decreases the supply of money to reduce the rate of inflation.

Question 19

Outline the steps of contractionary monetary policy.

Answer 19

• The central bank increases the base interest rate.
• Commercial banks then pass on this increase to households and firms.
• Firms and households receive more interest on the funds they hold in banks.
• Lower borrowing and higher saving rates decrease consumption.
• As consumption and investment fall, aggregate demand decreases.
• The decrease in aggregate demand leads to a fall in GDP and this leads to a fall in inflation and economic growth.

Question 20

List the strengths of contractionary monetary policy.

Answer 20

• Can be applied quickly
• Can be applied incrementally to adjust to inflation rate changes.
• Not as subject to political influence.

Question 21

List the weakness of contractionary monetary policy.

Answer 21

• The fall in aggregate demand will lead to a reduction in economic growth and even a recession.
• The increase in interest may not be passed on by the commercial banks.
• Time lags in the application can lead to policy errors.
• The increase in interest rates can lead to an appreciation in the interest rates.