monetary policy Flashcards
money
anything generally accepted as a means of payment
evolution of money
barter (requires double coincidence of wants, limits specialisation) –> commodity money (had intrinsic value like gold & silver) –> backed paper money (convertible to valuable commodities) –> flat money (backed by government decree, no intrinsic value)
modern forms of money
cash, demand deposits (checking accouts)
money supply
current in circulation + demand deposits
4 key functions of money in an economy
medium of exchange, unit of account, store of value, standard of deferred payment
money as a medium of exchange
facilitates transactions by being universally accepted as payment, eliminating the need for barter
money as a unit of account
provides a common yardstick for measuring and comparing values of various goods and services simplifying economic computations and comparisons
money as a store of value
allows purchasing power to be held over time, enabling saving and investments for future needs. high inflation erodes this function by reducing the value of money over time
money as a standard of deferred payment
serves as a medium for future transactions, allowing individuals and businesses to make agreements today with the understanding that payment will occur at a later date
banking system
comprises central bank and commercial banks
central bank
sole issuer of notes, manages government bonds (Issuing, repaying, collecting), conducts monetary policy (managing interest rates or money supply), manages exchange rate policy, regulates and supervises commercial banks, acts as a “lender of last resort” to commercial banks in emergencies
commercial banks
play crucial role in financial system by connecting borrowers and lenders. they take deposits from individuals and businesses (who want to earn interest on their savings) and use those funds to make loans to others (who need money for various purposes). essentially matches supply and demand in the credit market.
deposits
people deposit money in their banks, earning interest on their savings
loans
banks use deposits to make loans to borrowers, charging them a higher interest rate than they pay to depositors. this difference in interest rates is how banks make profit.
fractional reserve banking
banks don’t need to keep all the deposited money in their vault and can lend out a portion of it because its highly unlikely that everyone will withdraw their money at the same time.
reserve requirement ratio (RRR)
determines minimum percentage of deposits banks must keep as reserves (either in cash in their vaults or as deposits at the central bank). remaining amount is called excess reserves and can be used for further lending.
fractional reserve banking system allows banks to
expand money supply & manage risk
expanding money supply using fractional reserve banking
by lending out portion of deposits, banks create new money in the form of loans which can boost economic activity.
managing risk using fractional reserve banking
keeping reserves (based on RRR) ensures banks have enough cash on hand to meet withdrawal demands and avoid potential bank runs.
risks of fractional reserve banking
if too many people try to withdraw their money at once, banks could run out of cash and face a crisis. this is why central banks closely monitor and regulate banks
fractional reserve banking in action
creates money through a chain reaction of deposits and loans
money supply due to fractional reserve banking
central bank can influence money supply by adjusting RRR, fuels economic activity
transactions motive
people need cash for everyday transactions and purchases, making holding money essential. this demand increases with nominal income, inflation and real income.
precautionary motive
people also demand money as a safety net against unexpected events like job loss, medical emergencies or car repairs.
speculative motive
involves holding money in anticipation of future changes in interest rates or asset prices
opportunity cost
holding money means sacrificing potential interest earned by investing in assets like bonds; convenience of immediate access to money vs. forgone interest
holding money
for the practical need to conduct transactions, but the amount they hold depends on a trade off between convenience and potential returns from other investments.
demand for money
finite & negatively related to interest rates, higher income and inflation increase demand for transactions, higher interest rates decrease quantity demanded as alternative investments become more attractive.
movement along money demand function
assuming fixed level of nominal income (Y), and money demand function (Md), when interest rates increase (from r1 to r2) & the opportunity cost of holding money rises, motivates people to hold less money leading to a decrease in quantity demanded from M1 to M2
shift of money demand function
suppose nominal income increases (from Y or Y’) due to factors like rising price level or real GDP growth. increases need for money to conduct transactions at all interest rates. consequently, the entire Md function shifts to right, becoming M’d. at the initial rate (r2), the demand for money rises to M’2, which is higher than the previous M’2.
central bank & equilibrium interest rate
equilibrium interest rate r(e) where quantity of money demanded (Md) equals to quantity supplies (Ms). central bank sets Ms (however much is required to achieve r(e) OR central bank sets r(e) (Ms will adjust accordingly)
monetary policy
tool used by country’s central bank to influence economy by adjusting money supply or interest rates. this affects aggregate demand and aims to achieve economic goals like price stability and full employment.
monetary policy goals
price stability, economic mandate, dual stabilisation, promoting economic growth, influencing exchange rates
price stability (MP goal)
maintaining low and stable inflation (usually around 2%) to avoid economic disruption
dual mandate (MP goal)
balancing price stability with maximising employment, although achieving both simultaneously can be challenging
economic stabilisation (MP goal)
minimising business cycle fluctuations by responding to recessionary risks and inflationary pressures
promoting economic growth (MP goal)
a stable and predictable macroeconomic environment with low inflation encourages investment and job creation
influencing exchange rate (MP goal)
monetary policy can adjust the currency value, making exports more competitive if needed
required reserve ratio (RRR)
determines the minimum percentage of deposits banks must hold as reserves. decreasing RRR increases excess reserves and lending, expanding the money supply (right shift). increasing RRR reduces excess reserves and lending, contracting the money supply (left shift).
discount rate
special interest rate on loans from the central bank to commercial bank. lowering the discount rate makes borrowing cheaper, encouraging lending and expanding the money supply. raising the discount rate discourages borrowing and contracts the money supply.
open market operations
central bank buys/sells short-term government bonds to banks. buying bonds injects or increase reserves into banks, increasing lending and the money supply. selling bonds withdraws or reduces reserves, reducing lending and money supply. primary tool for monetary policy adjustment.
quantitative easing (QE)
unconventional tool used after the 2008 crisis due to near-zero interest rates. central banks purchase large quantities of longer-term assets (bonds, mortgages) from banks. injects significant reserves into banking system, simulating lending.
changes in interest rates
to fight recession and unemployment & to fight inflation
changing interest rates to fight recession & unemployment
using expansionary policy: decrease interest rates or by increasing money supply. can be done by lowering reserve requirements, decreasing discount rate or buying government bonds. increased money supply leads to lower interest rates (or vice versa), encouraging borrowing and spending, boosting aggregate demand
changing interest rates to fight inflation
using contractionary policy: increase interest rates or by deceasing money supply. can be done by raising reserve requirements, increasing the discount rate, or selling government bonds. decreased money supply leads to higher interest rates (or vice versa), discouraging borrowing and spending, slowing down aggregate demand and inflation.
expansionary MP to stimulate AD
decreasing interest rates by lowering discount rates & increasing money supply
decreasing interest rates by lowering discount rates (expansionary MP to stimulate AD)
commercial banks will borrow more from central bank for its loan business, increasing money supply
increasing money supply (expansionary MP to stimulate AD)
open market purchases of bonds by central bank, injecting more money into the economy hence, reducing interest rates
aims of expansionary MP on AD
increase consumption, investment and net exports
increase consumption (expansionary MP on AD)
lower interest rates make borrowing for purchases more attractive, leading to excess spending
increased investment (expansionary MP on AD)
businesses are more likely to invest in new projects when borrowing costs are lower
increase next exports (expansionary MP on AD)
lower interest rates result in a weaker domestic currency due to the outflow of “hot money” to the foreign exchange rate market making exports more competitive, boosting net exports
reasons for increased consumption expenditure (expansionary MP on AD)
reduced borrowing costs: borrowing for durables and houses become cheaper, leading to higher spending. considered the primary route for monetary policy to impact AD.
decreased saving incentive: lower interest rates make saving less attractive (lower opportunity cost in investment), encouraging people to spend more. this is less significant than borrowing cost effect.
reasons for increased investment (expansionary MP on AD)
cheaper borrowing: firms face lower costs to finance new projects, making investments profitable.
decreased saving incentive: lower interest rates make saving less attractive (lower opportunity cost in investment), encouraging firms to invest more. this effect is less significant than borrowing cost effect.
reasons for increased next exports (expansionary MP on AD)
lower rate of returns: savings accounts and other interest-bearing accounts see lower returns from their deposited funds. speculating financial investors will switch to financial assets of other countries offering higher interest returns. outflow of “hot money” to the foreign exchange market occurs depreciating the country’s currency making exports cheaper abroad and imports more expensive, increasing net exports.
contractionary MP on AD
increasing interest rates via raising discount rates: commercial banks will borrow less and will pay back loans to central bank, decreasing money supply.
decreasing the money supply via open market selling of bonds by the central bank, reducing money supply in the economy and hence, increasing interest rates.
reasons for decreased consumption expenditure (contractionary MP on AD)
increased borrowing cost: borrowing for durables and houses becomes more costly, leading to lower spending. this is considered the primary route for MP to impact AD.
increased saving incentive: higher interest rates make saving more attractive (higher opportunity cost in spending), encouraging people to spend less. However, this effect is less significant than borrowing cost effect.
reasons for decreased investment (contractionary MP on AD)
increased borrowing cost: firms face higher costs to finance new projects, making investments less profitable.
increased saving incentive: higher interest rates make saving less attractive (higher opportunity cost in investment), encouraging firms to invest less. However, this effect is less significant than borrowing cost effect.
reasons for decreased net exports (contractionary MP on AD)
higher rate of returns: savings accounts and other interest-bearing accounts see higher returns from their deposited funds. speculating financial investors will switch to financial assets of the country offering higher interest returns. inflow of “hot-money” increases demand for domestic currency in the foreign exchange market, appreciating the country’s currency making exports more costly abroad and imports cheaper, decreasing net exports.
nominal interest rates
advertised rates banks offer for deposits and loans
real interest rate
true cost of borrowing and earning, adjusted for inflation
formula for real rate
real rate = nominal rate - inflation rate
implications of nominal and real interest rates
low nominal interest rates during deflation, meant to encourage borrowing and spending to simulate AD, might backfire due to a higher real interest rate. higher real interest rate actually discourages borrowing and spending, limiting the effectiveness of monetary policy in combating deflation.
strengths of monetary policy
flexibility, incrementally, reversibility, independence, shorter time lags
flexibility of MP
central banks can quickly adjust (raise, pause or cut) interest rates to changing economic conditions
incrementality of MP
adjustments can be made gradually as small as 0.25%, avoiding drastic changes, over-addressing
reversibility of MP
mistakes can be corrected by reversing course or when economic conditions change.
independence of MP
central banks are less susceptible to political pressure
shorter time lags of MP
quick implementation or short implementation lag hence, often referred to as a first responder policy as compared to fiscal policy requiring lengthy legislative process which may take months.
limitations of MP
limited effectiveness in fighting recessions & zero lower bound (ZLB) constraint
