Monetary Policy

Question 1

What is a monetary policy?

Answer 1

The process by which monetary authority, like central bank, controls the supply of money, often targeting interest rates to ensure price stability

Question 2

What is a central bank

Answer 2

A national bank that implements the monetary policy and prints currency

Question 3

Role of central bank: banker to the government

Answer 3

• holds the government’s cash
• receives payments for government and makes them
• manages government’s borrowing by selling bonds to commercial banks and to the public, acts as an adviser to the government on financial and banking matters

Question 4

Role of central bank: conduct monetary policy

Answer 4

The central bank is responsible for monetary policy, based
on changes in the supply of money or the rate of interest.

Question 5

Role of central bank: banker to commercial banks

Answer 5

• holds deposits for them and can also make loans to them in times of need
• not a banker to consumers and firms

Question 6

Role of central bank: regulator of commercial banks

Answer 6

• regulates and supervises commercial banks
• makes sure they operate with appropriate levels of cash and according to rules that ensure the safety of financial system

Question 7

Goals of monetary policy

Answer 7

Low and stable rate of inflation
- low unemployment
- reduce business cycle fluctuations
- promote a stable economic environment for long term growth
- external balance of exports and imports

Question 8

Explain central bank independence

Answer 8

Although the central bank is usually a government institution, it has a degree of independence from government interference in the pursuit of monetary policy
- independence ensures that monetary policy can be conducted in the best longer term interests of the economy, without interference from political pressures (elections)

Question 9

What is inflation targeting and what centra bank uses

Answer 9

Monetary policy regime in which a central bank has a target inflation rate for the medium term and announces this inflation target to the public
- The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability.
● The central bank uses interest rates, its main short-term monetary instrument.

Question 10

Name 5 advantages of inflation targeting

Answer 10

1. Lower average rates of inflation
2. More stable rates of inflation
3. More accurate inflation expectations of firms and consumers
4. Better coordination between monetary and fiscal policies
5. More transparency and accountability of central banks

Question 11

Name 5 disadvantages of inflation targeting

Answer 11

1. Central bank has reduced abilities to control other objectives ( low unemployment)
2. Central bank may have reduced the ability to respond to supply-side shocks
3. Central bank may have reduced ability to respond to unexpected events (financial crises)
4. Determining an appropriate inflation target
5. Implementation difficulties (requires forecasting which can be unreliable)

Question 12

Nominal rate of interest

Answer 12

• market rate that prevails at any moment in time. If your bank tells you that you will receive 5% interest on your savings, that is the nominal
  interest rate.

Question 13

Real rate of interest

Answer 13

Interest rate that has been corrected for inflation.
Nominal rate - inflation = real rate

Question 14

Expansionary monetary policy

Answer 14

An increase in the money supply by the central bank is referred to as an expansionary policy since the objective is to expand aggregate demand and the level of economic activity
- therefore, lower interest rates will tend to increase consumer spending and investment

Question 15

Contractionary monetary policy

Answer 15

A decrease in the money supply by the central bank is referred to as a contractionary policy, as the objective is to contract aggregate demand and therefore the economy
- therefore, higher interest rates will tend to decrease consumer spending and investment

Question 16

Constraints on monetary policy: possible ineffectiveness in recession

Answer 16

• Interest rates cannot fall when approaching zero
  As interest rates approach zero, they cannot fall further to encourage spending by firms and consumers
• Low consumer and producer confidence
  If firms and
  consumers are pessimistic about future economic conditions,
  they may avoid taking out new loans, and may even reduce
  their investment and consumer spending, so that aggregate
  demand will not increase.
• Banks may be fearful of lending
  In a severe recession,
  banks may be unwilling to increase their lending, because
  they may fear that borrowers might be unable to repay the
  loans.

Question 17

Constraints on monetary policy: conflict between government objectives

Answer 17

Manipulation of interest rates affects not only variables in
the domestic economy (consumption and investment
spending, inflation, unemployment) but also variables in
the foreign sector of the economy, such as exchange rates.

Question 18

Constraints on monetary policy: may be inflationary

Answer 18

If it lasts too long it may be
inflationary, if aggregate demand increases beyond what is
necessary to eliminate a deflationary/ recessionary gap.

Question 19

Constraints on monetary policy: Problematic when dealing with stagflation or
cost-push inflation.

Answer 19

Monetary policy is a demand-side
policy, and is therefore unable to deal effectively with
supply-side causes of instability.

Question 20

Strengths of monetary policy: Interest rate changes can be incremental

Answer 20

Interest rates
can be adjusted in very small steps, making monetary policy
well suited to ‘fine tuning’ of the economy.

Question 21

Strengths of monetary policy: ?

Answer 21

●Interest rates changes are reversible.

Question 22

Strengths of monetary policy: short time lags

Answer 22

While monetary
policy can be implemented relatively quickly, it is subject to time lags as it takes time for interest rate changes to affect the economy, though these are not as long as in the case of fiscal policy.

Question 23

Strengths of monetary policy: Central bank independence.

Answer 23

Independence from the government discussed above means the central bank can take decisions that are in the best longer-term interests of the economy, and can therefore pursue policies that may be politically unpopular (such as higher interest rates making borrowing more costly).

Question 24

Strengths of monetary policy: no budget deficit or debt

Answer 24

It does not lead to budget deficits or increased levels of debt as fiscal policy does in the case of expansionary policy.