4.4 - Monetary Policy

Question 1

Monetary policy

Answer 1

Monetary policy involves changes in the money supply and/or interest rate in an economy to influence the level of total demand and economic activity
* also used by a government to influence the exchange rate of its national currency against foreign currencies: to affect the level of international trade and transactions

Question 2

Money supply

Answer 2

The amount of money in an economy at any given moment in time (i.e. coins, bank notes, bank deposts and central bank reserves)

Question 3

Three main instruments of monetary policy

Answer 3

1. Interest rates
2. Quantitative easing
3. Exchange rates

Question 4

How are interest rates used to effect the economy?

Answer 4

Used through incremental adjustments to effect savings, borrowings and spending by consumers

Question 5

Quantitative easing

Answer 5

A process whereby the central bank buys back governmental bonds from the open market

Question 6

How is quantitaive easing used to effect the economy?

Answer 6

It increases the supply of money in the economy:
* The Central Bank creates new money & uses it to buy open-market assets such as bonds
* When they buy the bond back early, there is an injection of new money into the economy

Question 7

How are exchange rates used to effect the economy?

Answer 7

The Central Bank influences the exchange rate through buying or selling its own currency: influences the level of exports/imports

Question 8

Expansionary monetary policy

Answer 8

Includes reducing interest rates, increasing QE, or depreciating the exchange rate
- in order to generate further economic growth

Question 9

Contractionary monetary policy

Answer 9

Includes increasing interest rates, decreasing/stopping QE, or appreciating the exchange rate
- in order to slow down economic growth or reduce inflation

Question 10

How does a central bank increase the money supply?

Answer 10

1. Fractional reserve requirement
2. Discount rate
3. Open market operations

Question 11

Fractional reserve equirement

Answer 11

A system in which a fraction of bank deposits are required to be available for withdrawal in a bank

Question 12

Strengths of monetary policy (name 3)

Answer 12

• The central bank operates independently from the Government (political process)
• Is able to consider the long-term outlook
• Targets inflation & maintains stable prices
• Depreciating the currency can increase exports

Question 13

Weaknesses of monetary policy (name 3)

Answer 13

• Conflicting goals
• Time lags between policy & the desired impact (up to 2 years)
• Firms & consumers may not respond to lower interest rates when confidence is low
• Cheaper loans may inflate asset prices (e.g. property) in the long term
• The interest rate has limitations on downward adjustment - the closer the rate gets to zero, the less effective