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EC102 > Monetary Policy > Flashcards

Monetary Policy Flashcards

1
Q

Central Banks

A
  • Central Banks: Federal Reserve, BOE, ECB, Bank of Japan
  • Goal: to counter demand shocks
  • Monetary Policy affects interest rates
  • Interest rates affect C and I
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2
Q

Interest Rates

A

Many forms of borrowing in the economy:
- Firms and households borrow from banks

  • Households borrow using credit cards
  • Firms and governments borrow from the public by issuing bonds
  • Interest rate is the per-unit value compensation
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3
Q

Interest Rates Tend to Move Together

A
  • If the interest rate on one form of borrowing goes up, interest rates on other forms of borrowing will also go up

Examples:

  • Interest rate on government bonds goes up
  • Demand for corporate bonds goes down
  • Interest rate on corporate bonds go up
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4
Q

What is a Central Bank?

A
  • The commercial bank’s bank
  • Offers depositors to commercial banks (bank reserves?)
  • Lends to commercial banks
  • Monopoly supplier of legal tender
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5
Q

Policy Rates

A
  • Interest rates that are set directly by the central bank
  • Rates on bank reserves
  • Rates on loans to commercial banks
  • By changing policy rates central banks can affect all other rates in the economy

Example:

  • Interest rate on central bank loans goes down
  • Financing for commercial banks becomes cheaper
  • Commercial banks require lower interest rates to lend to firms and household
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6
Q

Interest Rates and I or C

A
  • Cash-poor firms: cost for borrowing

- Cash-rich firms: opportunity cost??

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7
Q

Counter-Cyclical Monetary Policy

A
  • Lower interest rates in response to contraction are aggregate demand shocks
  • Increased interest rates in response to expansionary aggregate demand shocks
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8
Q

The risks of expansionary countercyclical policy

A
  • Monetary (and fiscal) expansions generate inflation when the economy is at or above the natural rate of output, or when they push the economy above the natural rate
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9
Q

The Effective Lower Bound = Effective lowest interest rate

A
  • Paying banks to keep money safe
  • Negative interest rates: incentive to borrow and hoard cash
  • Minimum interest rate (ELB): cost of storing cash (only (protecting))
  • When interest rates are at the ELB, conventional monetary policy becomes ineffective (can’t lower rates anymore, rising would be stupendous)
  • Until recently it was thought the ELB was 0 (ZLB)
  • (On the other hand, has been used as a policy by Japan and Switzerland to stimulate spending)
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10
Q

Getting around ELB

A
  • Abolishing paper currency (easier to create numbers than physically print moneys/doesn’t add money directly)
  • Abolishing large denominations (costs a lot to store cash)
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11
Q

QE/Unconventional Monetary Policy

A
  • Long-term usually have positive interest rates even when short-term ones are at zero or negative
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12
Q

Properties of Yield Curve

A
  • Short-term and Long-term rates move together

Liquidity premium:

  • Lenders require premium for licking money in (no access in case of emergency/opportunity)
  • Curve slopes up most of the time

QE = IR on longer maturity bonds goes down

QE end game to lower interest rate

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13
Q

Bond Purchases and Interest Rates

A
  • Market for loans
  • Interest rates fall if the supply of loans goes up
  • Bonds are part of the market for loans
  • Purchasing a bond is a lending action
  • Increased purchases of bonds represent an increase in the supply of loans
  • That’s why they lower interest rates (high bond prices (as a result of high demand) = low interest rates)
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14
Q

QE and the central bank’s budget

A
  • Markets for long-dated assets are huge

- In order to affect yields, purchases must be huge as well

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15
Q

Other ways that QE might help

A
  • Keeping banks solvent by supporting asset prices (private shares, stock market support, gives banks capital)
  • Direct support for issuers of assets being purchased e.g. mortgages in US government bonds in Eurozone
  • Depreciating the exchange rate
    E.R. = price of domestic currency in terms of foreign currency (supply of money increases)
  • Psychological boost to investors and consumers (more confident in macroeconomic management)
  • Doesn’t effect interest rate
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16
Q

AD shocks: The government’s role

A

Fiscal policy - directly affects Y by G or C
- Decided by Parliament/Cabinet

Monetary Policy indirectly affects Y by interest rate mechanism
- Decided by Central Bank

Desire for low inflation and low unemployment -> trade offs

17
Q

Why Monetary Policy?

A
  • Fiscal policy is complicated to adjust and inflexible

Central banks set policy interest rate:

  • Rate on bank reserves
  • Rate on loans to commercial banks

Commercial banks set their bank lending rate/market interest rate:

  • Rate that commercial banks lend to households and firms
  • market rate changes with policy interest rate - determined privately by the commercial banks for profits
18
Q

Central banks are independent entities with power to issue reserves by setting interest rates (short-term nominal rate)

A

1) Central Banks issue reserve to commercial banks in exchange for buying things from them or loans
2) Commercial Banks exchange the reserves for currency
3) Central Banks satisfy the request

19
Q

Central Bank operations

A

Policy tightening -> Increasing rates: Reduce money supply
Policy expansion -> Reducing rates: Increase money supply

The change in monetary policy can lead to:

1) Expansion/Contraction of economy on outputs
- In normal times (when the economy is not in boom or recession) the economy prevails at its natural rate of output

2) Changes in prices
- In SR, prices adjust by going up/down with expansion/contraction back towards it natural rate of output

20
Q

Natural Rate of Output

A

Most efficient level of output produced when the economy is not in boom or recession

Properties of Yn:

  • By definition, Yn is invariant to the stimulus cycle. The economy will always return to this ‘natural’ level of output
  • Yn changes when there is resource change (i.e., technological, organisation, human capital and etc.)

Dynamics of Yn:

  • Growth in GDP not equal to growth in Yn
  • Inflationary pressure if Growth Y > Growth Yn: P increases
21
Q

Effects of change in monetary policy

A

1) Affects interest rate:
- The cost of taking out a loan will fall

2) Interest rate affects C and I
- Investors consider more new housing projects to be financially viable
- More jobs created, household consumption increases

22
Q

Monetary policy in times of shocks

A
  • Should be done within a very short time of the shock to push back to Yn
  • Doing too little might not push economy back
  • Doing too much might push output over Yn, causing inflation
  • If intervention is done after price changes, it is not useful -> policy must be implemented in the sticky price period to prevent inflation
23
Q

Yield Curve

A
  • As a lender you are only willing to invest for a longer period if the compensation (or returns) is higher -> liquidity premium
  • As a borrower you are usually happy to pay a higher rate to long-term assets so you can ‘lock in’
  • Short term rates will see a steeper yield curve as people prefer to buy short-term assets and have flexibility to switch around
24
Q

Central Banks’ balance sheet

A

Past

1) Assets: Mostly short-term gov bonds
2) Liabilities: Mostly currency

Present: QE

1) Asset mostly long-term gov bonds
2) Liabilities: currency and reserves

25
Q

Zero-Lower Bound

A

Monetary policy has a limit

  • Can be negative due to storage costs i.e. risk of thefts, paying bank to look after money
  • Central bank has maximised the expansion of money supply in the economy, central banks can create new money electronically (in reserve) to purchase long-term binds, so to stimulate AD (i.e. QE)
26
Q

QE

A

Central banks make purchase of long-term assets in large quantities

1) Large scale purchases increase demands push up prices and decrease yield (return to investments)
2) Money raised by asset sellers (i.e., gov) can buy other high yielding private-sector assets (i.e., company bonds and shares)
3) Again, private asset yields decrease by increased demands: borrowers benefit on lower rates, stimulate investments and spending
4) Other raises of bonds increase the assets sellers have leading to them having more money in their bank accounts which commercial banks can use to finance new loans that stimulate investment and spendings

In other words:
CB buys large qty of asset -> increase demand and price -> reduce aggregate yields (decrease in commercial interest rates) -> stimulate investment

EC102 (11 decks)

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