Module 16.2: Monetary Policy Flashcards
What are the three main tools of central banks?
1) Policy rate - how much banks and other can borrow from the central bank
2) reserve requirements - increasing the reserve requirements effectively decreases the funds that are available for lending and the money supply
3) Open market operations - buying and selling securities
What is the monetary transmission mechanism?
explains how a change in monetary policy affects the price level and inflation.
Explain the four things that happen with a central bank increases the policy rate?
What does it do to demand and the price level?
1) Banks short-term lending rates will increase in line with an increase in the policy rate. higher rates will decrease demand as consumers reduce credit purchases.
2) Asset prices will decrease as the discount rate applied to future cash flows are increased, may decrease demand because asset value went down.
3) Expectations for future economic growth might go down which decreases both consumer and business expenditure.
4) Increase in interest rates may attract foreign investment in debt securities, leading to an appreciation of domestic currency.
What are the three qualities a central bank should have to succeed in its inflation targeting policies?
1) Independence - no political interference. can be evaluated through operational independence (central bank can determine policy rate) and target independence (central bank also defines how inflation is computed, sets the target inflation level).
2) Credibility - following through on stated intentions allowing banks on other businesses to adjust to the stated intentions.
3) Transparency - using inflation reports, central banks state the economic environment.
What are three strategies central banks use to know when to begin using monetary policy?
1) Interest rate targeting - increasing money supply when the specific interest rates rise above a target band
2) Inflation targeting - when inflation reaches a certain level
3) Exchange rate targeting - “pegging”
What is the neutral interest rate? what is the formula?
growth rate of the money supply that neither increases nor decreases the economic growth rate. formula:
neutral interest rate = real trend rate of economic growth + inflation target.
What are some three limitations of monetary policy?
if people believe that a decrease in the money supply intended to reduce inflation will be successful, they will expect lower future inflation rates, and the long term rates could fall, even if short term rates increase.
money tightening could be viewed as too extreme and increase the probability of a recession, making long term bonds more attractive.
demand for money becomes very elastic and people hold onto cash even without a decrease in short term rates.
Why is fixing a deflation period with monetary policy harder than inflationary?
once the policy rate hits 0, you cannot go further.
