Monetary Policy Flashcards
What is Monetary Policy
It’s how central banks control money supply and interest rates to influence economic activity
What’s the Role of Central Banks
Examples:
Bank of England
Federal reserve (Fed)
European Central Bank
How they influence the economy:
Manage money supply
Increase money supply → Lower interest rates → More borrowing & spending
Decrease money supply → Higher interest rates → Less borrowing & inflation control
Four Key Tools of Monetary Policy
Open Market Operations - Buying and selling government bonds
Discount Lending - Loans from central bank to commercial banks
Reserve Requirements - Minimum deposits that banks have to keep hold of
Paying Interest on Reserve - Encouraging and Discouraging Bank Lending
What happens in Open Market Operations (OMO)
Central Bank buys or sells government securities (bonds) in the open market:
Buying bonds -> Increases Money Supply (Lowers interest rates, boosts borrowing)
Selling Bonds -> Decreases Money Supply (rises interest rates, slows inflation)
What’s Discount Policy (Lender of Last Resort, loans of financial crisis)
It’s when central banks provide short term loans to commercial banks to manage liquidity
Types of Loans:
Primary Credit - For stable banks (lower interest rates)
Secondary Credit - For banks with liquidity issues (higher risk, higher rates)
Seasonal Credit - For small banks with seasonal demand (agriculture)
What are Reserve Requirements
It’s the minimum percentage of deposits banks must have in reserves
Different Types of Reserve Requirements
Required- The minimum amount of reserves that banks must legally hold and can’t lend out
Excess - Any reserves held above required minimum, which banks can keep or lend
The Effects of Increased or Decreased Reserve Requirements
Increased -> Less Lending -> Higher Interest Rates:
More held funds reduce amount available to lend, money supply low so higher interest rates
Decreased -> More Lending -> Lower Interest Rates
Banks hold less reserve, needing more lending, leading to a higher money supply, leading to lower interest rates
Why Reserve Requirement is Rarely Used
Sudden changes can disrupt liquidity
OMO and interest rates are preferred monetary policies
What are the 3 Goals of Monetary Policy
Price Stability - Controls inflation and stability
Maximising Employment - Ensures job market stability
Promoting Economic Growth - Supports long term expansion
Why is Price Stability Important
High inflation creates uncertainty in investment and plans
Reduces purchasing power, so money buys less over time (hurting low income groups)
Hyperinflation can cause economic collapse (Weimar Germany)
Two ways Central Banks Maintain Price Stability
Set an inflation target (e.g. 2%)
Utilise Monetary tools (OMO) to regulate money supply and maintain stable inflation
Why Maximising Employment is Important
Monetary policies aim to match demand with supply by having the lowest unemployment rate without triggering inflation
Stable employment leads to higher wagers, stronger demand, stronger economy
How do Central Banks Promote Employment
Lowering interest rates to encourage borrowing and investments
Stabilise credit availability to allow businesses to expand and hire
Preventing unemployment spikes by stabilising economic fluctuation (adjust monetary policy)
Why is Promoting Economic Growth Important
It leads to higher living standards
Creates Jobs and national wealth
How Central Banks Support Growth
Keep inflation low and predictable to boost business confidence
Ensure financial system stability to allow smooth investments
Adjust monetary policy to support long term GDP growth
