monetary policy chapter 23 Flashcards
central bank
bank owned by the government that provides banking services to the government and commercial banks and which operates monetary policy
commercial banks
banks which aim to make a profit by providing a range of services to firms and households
monetary policy
the use of interest rates, the money supply, credit regulations and the exchange rate to influence aggregate demand. it is mainly used to influence the price level
interest rates
the price of borrowing money and the reward for saving. the interest rate charged by the central bank may be called the bank, base, repo or often just the interest rate.
money supply
the total amount of money in a country
who uses monetary policy
usually applied by the central bank of the country or area
how can interest be used as a monetary policy
central banks use it to control inflation and influence economic activity. it is the price of money. households and firms who want borrow money have to pay interest and ones that lend money are paid interest. changes in the interest rate have been mainly used to achieve price stability.
how is money supply used as a monetary policy
a central bank may also target the money supply in the economy as changes in the quantity of money in the economy can influence AD. a central bank can electronically print money but the main cause of changes in the money supply is lending by commercial banks. it is for this reason that central banks often seek to influence lending by commercial banks
how can exchange rate be used as a monetary supply
most economists also include the exchange rate as a monetary policy tool. central banks may manipulate the exchange rate to raise or lower AD and so influence, for example, price stability
how can exchange rate be used as a credit regulation
central banks may also impose credit regulations on commercial banks to help maintain financial stability and to influence bank lending. most central banks require the country’s commercial banks to hold a proportion of their assets in a form that can be quickly sold and so converted into cash. this is to ensure the commercial banks can meet their customers’ likely demand for cash even during a financial crisis
expansionary monetary policy
expansionary monetary policy may be used to increase AD. a cut in the interest rate, n increase in the money supply and a reduction in any restrictions on bank lending can be used to achieve an increase
contractionary monetary policy
to reduce AD or the growth of AD, contractionary monetary policy may be used. this include a rise in the interest rate, a decrease in the money supply and restrictions on bank lending
credit regualtions
rules affecting bank lending
target rate for inflation
the rate a central bank is set to achieve
what is the main policy used to reduce demand-pull inflation
it is monetary policy with the focus being on the interest rate
what is used to achieve target rate of inflation
many central banks are now given a target rate for inflation and instructed to use interest rate changes to achieve it.
how is interest rate used to achieve target rate of inflation
if the inflation rate is rising outside its target range, a central bank is likely to raise the rate of interest to reduce AD
how can interest rate be a contractionary monetary policy used to reduce demand pull inflation
The cost of borrowing is likely to rise which may discourage large-scale purchases including the purchase of houses and cars. Savings may be increased as the return from saving will rise. The opportunity cost of saving is, of course, spending.
how lowering the growth of the money supply be used to reduce inflationary pressure
Monetarists argue that the only way to reduce inflationary pressure is to lower the growth of the money supply. If increases in the money supply do not exceed increase in output, they suggest there will be no upward movement of the price level.
how do commercial banks change their interest rate
they usually do keep their interest rates in line with the interest rates of the central bank as it is the rate they will have to pay if they need to borrow from the central bank. There is, however, no guarantee that they will always raise their interest rates when the central bank increases its rate.
why cant the rise in interest rate not discourage consumer expenditure
Even if consumers are faced with higher interest rates, they may not reduce their spending if they are optimistic about the future.
why cant the increase in income tax not discourage consumer expenditure
The same applies to a rise in income tax where households may cut their saving rather than their spending if they think their incomes will rise in the future.
how does the rise in interest rate have an adverse effect on investment
it will increase the cost of borrowing funds to invest and will increase the opportunity cost of using profits to invest. The capital stock will decline if investment falls below depreciation. The resulting decrease in aggregate supply can push up the price level.
what constraints can countries face on the monetary policy measures that they can use to correct inflation
Central banks may be worried that if they raise interest rates higher than in other countries, they may attract an inflow of money into their financial institutions from abroad. This may increase their exchange rates. Countries that are members of an economic union may operate the same interest rate and the same exchange rate as other members and the area’s central bank may make the decisions on these areas of monetary policy.
why would a government try to not stop deflation
it will not stop good deflation but it will try to correct bad deflation
how does a government seek to correct bad deflation
A government may try to reverse a fall in aggregate demand by using expansionary monetary policy. However, a decrease in the rate of interest and/or an increase in the money supply may not work because firms and households may be pessimistic during periods of deflation and so may not spend more even if there is more money in circulation and becomes cheaper to borrow.
why can monetary policy not be very effective in increasing aggregate demand when the rate is low or negative.
firms and households may be pessimistic during periods of deflation and so may not spend more even if there is more money in circulation and becomes cheaper to borrow.
what happens when central banks increase the money supply
central banks may increase the money supply, increasing the funds commercial banks have available to lend. the banks, however, may be reluctant to lend because they may think there is an absence of creditworthy borrowers
what happens when an expansionary used if there is spare capacity in the economy
it may result in higher national income. a cut in the rate of interest or an increase in the money supply may encourage more consumer expenditure and investment. the higher aggregate demand can increase real output
what is higher output likely to result in
higher output is likely in an increase in employment. extra workers will be taken on to produce more goods and services
what is the risk of monetary policy
it may reduce national income, output and employment. however, if it is used when the economy is operating with all resources employed, it may reduce the inflation rate. without the downward pressure on the growth of consumer expenditure and investment, the price level would rise
why can it be difficult to control the money supply
This is partly because commercial banks have a strong incentive to try to increase their lending and may seek to get round any limits a central bank seeks to place on the growth of their lending. Trying to control certain forms of money may lead to new forms of money being used.
problems with using interest rates
There is a time lag between changing interest rates and the full effect being transmitted to the macroeconomy. Some economists have estimated that it can take as long as 18 months for interest rate changes to have their full impact. This is, however, less time than in the case of some fiscal policy measures.
effect of interest rates
Some households and firms are more likely than others to cope with a change in the interest rate. A higher interest rate may also have an adverse effect on unemployment and economic growth, as with a deflationary fiscal policy measure.
how does the mobility of financial investment affect the usage of interest rates
With increasing mobility of financial investment, it can be difficult for a country to operate an interest rate that is significantly different from rival countries.
