central banks and monetary policy Flashcards
what are the main functions of a central bank ?
A central bank is the government’s bank that issues currency and controls the supply of money in the economy
Central banks play a vital role in maintaining stability in the financial system
The policy tools at their disposal help to meet government macroeconomic objectives
role of the central bank
the governments bank
Banker to the banks— lender of last resort
Regulation of the banking industry
Implementation of monetary policy
banker to the government ?
The government sets the annual budget, but it is the Central Bank that manages the tax receipts and payments. In 2022, there were 5.7 million public sector workers in the UK who had to be paid each month
banker to banks - last resort ?
Commercial banks are able to borrow from the Central Bank if they run into short-term liquidity issues. Without this help, they might go bankrupt, leading to instability in the financial system and a potential loss of savings for many households
Regulation of the banking industry
The high level of asymmetric information in financial markets, it requires that commercial banks be regulated in order to protect consumers.
One of the key regulatory actions to manage the money supply and promote stability in the financial system is the implementation of required reserve ratios.. Raising the ratio decreases the money supply in the economy, and
Implementation of monetary policy?
This involves the Central Bank taking action to influence interest rates, the money supply, credit and the exchange rate
what is the monetetary policy used to help?
Monetary policy is used to help the government achieve their macroeconomic objectives
what does the monetary policy aim to achieve?
A low and stable rate of inflation
Low unemployment
Reduce trade/economic cycle fluctuations
Promote a stable economic environment for long-term growth
To control the level of exports and imports (net external balance)
When a policy decision is made, it creates a ripple effect through the economy, impacting the macroeconomic objectives of the government
what is expantionary monetary policy?
Expansionary policies include reducing interest rates, increasing QE, or depreciating the exchange rate
Expansionary monetary policy aims to shift aggregate demand (AD) to the right
draw expansionary monetary policy
diagram analysis
The economy is initially in macroeconomic equilibrium AP1Y1
The Central Bank wants to boost economic growth and lower interest rates
Lower interest rates cause investment and consumption to increase, which are components of AD
Aggregate demand increases from AD1→ AD2
The economy reaches a new equilibrium at AP2Y2 - a higher average price level and a greater level of national output
Expansionary Monetary Policy Impacts
effect on the economy - Commercial banks receive cash for their bonds → liquidity in the market increases → commercial banks lower lending rates → consumers and firms borrow more → consumption and investment increase → AD increases
impact on macroeconomic aims -
Economic growth increases
Inflation rises
Unemployment may fall as output increases and more workers are required
Net external demand worsens (with higher price levels exports may decrease and with rising incomes, imports may increase)
why may monetary policy be contractionary?
Monetary policy can be contractionary in order to slow down economic growth or reduce inflation (also referred to as tight monetary policy)
Contractionary policies include increasing interest rates, decreasing/stopping QE, or appreciating the exchange rate
Contractionary monetary policy aims to shift aggregate demand to the left
Contractionary Monetary Policy Impacts on the Goals
effect on the economy - Existing loan repayments for households become more expensive → discretionary income reduces → consumption decreases → total demand falls
Firms are less likely to borrow → less investment in capital takes place → AD falls
Hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases
impact on macroeconomics aims - Economic growth slows down
Inflation eases
Unemployment may increase as output is falling and fewer workers are required
Net external demand is likely to worsen as both exports and imports reduce (exports more expensive due to higher exchange rate and imports cheaper - but households have less income for imports)
exam tip
When analysing monetary policy, it is worth noting that monetary policy (4-8 x per year) can be adjusted more quickly than fiscal policy (usually once per year). However, the impact of fiscal policy is more predictable than the impact of monetary policy. For example, households may not borrow more money if their confidence in the economy is low - irrespective of how low interest rates go.
