monetary policy Flashcards
How does monetary policy transmission work?
Central bank sets policy rate → affects market interest rates.
Lower rates → ↑ asset prices, ↑ confidence → ↑ investment (I) and consumption (C).
Exchange rate ↓ → net exports (X−M) ↑.
AD shifts → stabilizes output/employment.
What is the Fisher equation, and why does it matter?
Real interest rate (r) = Nominal rate (i) − Expected inflation (πe).
Firms/investors care about real rates:
High inflation → r ↓ → cheaper borrowing.
Deflation → r ↑ → discourages spending.
What are the limitations of monetary policy?
Zero lower bound (ZLB): Nominal rates can’t go below 0%.
Eurozone dilemma: No national control for members (ECB sets one rate).
QE: Used at ZLB (buys bonds to ↓ long-term rates).
How does the exchange rate channel work?
Rate cut → currency depreciates → exports ↑, imports ↓ → AD ↑.
Example: Australia’s RBA cuts rates → AUD ↓ → boosts mining/agriculture exports.
What is inflation targeting?
Central bank aims for low, stable inflation (e.g., 2%).
Uses interest rates to steer AD:
Inflation > target → raise rates.
Inflation < target → cut rates.
Key benefit: Anchors expectations, prevents wage-price spirals.
Why did central banks gain independence?
Avoid political cycles (e.g., pre-election stimulus → inflation).
Post-1970s lessons: Independent banks achieved lower inflation (Figure 15.20).
How does QE work when rates hit ZLB?
Central bank buys bonds → injects money → ↓ long-term rates.
Effects: ↑ asset prices, ↑ housing/durable goods spending.
What happens if unemployment < equilibrium?
Inflation rises → central bank raises rates to cool AD.
Phillips curve shifts up if sustained (rising inflation expectations).
How did inflation targeting handle supply shocks?
Temporary inflation spikes (e.g., oil prices) ignored if expectations anchored.
Avoided 1970s-style stagflation by not overreacting.
What’s the ideal policy outcome (Point X)?
Inflation at target (e.g., 2%).
Unemployment at natural rate (no bargaining gap).
Stable Phillips curve.
