macro 3.5- demand management —monetary policy

Question 1

define monetary policy

Answer 1

the set of official policies governing the supply of money and the level of interest rates in an economy (usually employed by central bank)

Question 2

give and describe the two types of monetary policy

Answer 2

Expansionary monetary policy – increase aggregate demand
Contractionary/deflationary monetary policy – reduce aggregate demand

Question 3

what is the base rate (discount rate or prime rate) of interest set by?

Answer 3

the country’s central bank, which is essentially the government’s bank and the ultimate authority in control of the money supply in an economy.

Question 4

state the 6 goals of monetary policy

Answer 4

Low and stable rate of inflation and inflation targeting
Low unemployment
Reduce business cycle fluctuations
Promote a stable economic environment for long-term growth
External balance
Real versus nominal interest rates

Question 5

Low and stable rate of inflation and inflation targeting

Answer 5

Tied in with ‘inflation targeting’, where the bank sets a specific medium-term target inflation rate as a goal

Question 6

External balance

Answer 6

To achieve an external balance between export revenue and import expenditure

Question 7

Real versus nominal interest rates

Answer 7

The nominal rate of interest is the rate of interest available in the money market, not allowing for inflation.
The real rate of interest is the rate of interest adjusted for inflation
Real rate of interest = nominal rate of interest – inflation rate

Question 8

what does expansionary monetary policy involve? what are the results of this?

Answer 8

• lowering the base rate of interest.
• this reduces the cost of borrowing and can lead to increases in both consumption and investment.
• the bank could also increase the supply of money, which would lower its price

Question 9

what is the trade-off of expansionary monetary policy?

Answer 9

lower unemployment and higher inflation

Question 10

draw two diagrams to show the effects of expansionary monetary policy

Question 11

Constraints on monetary policy, including:

Answer 11

Limited scope of reducing interest rates, when close to zero:
- Expansionary monetary policy through cuts in the rate of interest cannot be used for ever
- Eventually interest rates will start to approach zero and there will be no room left for further cuts
Low consumer and business confidence:
- Even though interest rates are reduced, the effect on expenditure may be very much dampened by low consumer and business confidence.
- This is especially the case if the economy is in a deep recession.
Time Lags:
- Take some time to have an effect on the economy, may take a number of months before there is a noticeable effect on AD
- In this time, economic tractors may have changed and the policy may be inappropriate

Question 12

Strengths of monetary policy, including:

Answer 12

Incremental, flexible and easily reversible:
- Relatively quick to put in place- interest rate is set by the central bank and can be altered quickly when it is felt to be necessary, no political intervention needed before the rate can be changed
- Absence of crowding out
- Ability to make small changes – it is possible to be more precise than fiscal policy and set more exact targets.