12.3 Monetary policy

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monetary policy:

-carries out by the central bank of each country

central bank: a government financial institution with a number of responsibilities:

1. banker to the government:

-holds the government's cash

-receives payments for the government

-makes payment

-manages government's borrowing by selling and bonds to commercial banks and the public

2. banker to commercial banks

-acts as a banker to commercial banks by holding deposits for them

-can also make loans to them in times of need

3. regulator of commercial banks

-make sure that they operate with appropriate levels of cash and according to rules that ensure the safety of the financial system

4. conduct monetary policy

-responsible for monetary policy based on changes in the supply of money or the rate of interest

-usually responsible for the determination of exchange rates

supply of money:

-the demand for money shows the relationship between between the rate of interest and the quantity of money demanded and has a downward sloping curve

-as the rate of interest falls, the quantity of money demanded by the public (consumers, firms and the government) increases

-supply of money is fixed at a level that is decided upon by the central bank

-the point of intersection between Dm and Sm determines the equilibrium rate of interest

-an increase in the supply of money leads to a fall in the rate of interest

-a decrease in the supply of money leads to an increase in the rate of interest

controlling the money supply or the rate of interest:

-central bank decides upon a target interest rate it wants to achieve then take steps to adjust the money supply so that the actual equilibrium interest rate will become equal to the target interest rate

Monetary policy and AD:

-an increase in interest rates is intended to lower consumer and business borrowing and hence spending lowering C and I therefore AD shifts to the left

-a decrease in the interest rates in intended to increase consumer and business borrowing and hence spending increasing C and I therefore AD shifts to the right

-carries out by the central bank, which aims at changing interest rates to influence the I and C components aggregate demand

RECESSIONARY GAP

1. Expansionary monetary policy

-central bank may pursue and expansionary policy through lower interest rates to encourage I and C spending

-the objective being to shift the AD curve to the right leading to the equilibrium at the full employment level real GDP (potential GDP)

-an increase in the money supply by the central bank is referred to as an easy monetary policy (expansionary monetary policy)

INFLATIONARY GAP:

1. Contractionary monetary policy

-central bank can pursue a contractionary policy through higher interest rates aimed at discouraging I and C spending

-causes the AD curve to shift left leading to equilibrium at the full employment level of real GDP (potential GDP)

-a decrease in the money supply by the central bank is referred to as a tight monetary policy (contractionary monetary policy)

monetary policy and inflation targeting:

-targeting to achieve a level of inflation

-countries pursuing inflation targeting usually have targets of between 1.5% and 2.5% with one percentage point above and below as a tolerance margin

-to achieve this:

central banks use monetary policy

if predicted inflation is higher than the target, they use contractionary policy to increase the interest rates and lower AD therefore lowering the rate of inflation

if predicted inflation is lower than the target they use expansionary policy to lower interest rates and increase AD

Advantages of inflation targeting:

1. a lower rate in inflation

2. more stable rate or inflation

3. improved ability of economic decision makers (firms and consumers) to anticipate the future rate of inflation-central banks objectives are public knowledge

4. greater co-ordination between monetary and fiscal policy-knowledge about inflation allows government to plan fiscal policy better

5. greater central bank transparency and accountability- if central bank fails, it must explain to the nation why it failed

Disadvantages of inflation targeting:

1. reduced ability of the central bank to pursue other macroeconomic objective- focusing on inflation means less time for other objectives

2. reduces ability of the central bank to respond to supply side shocks

3. reduced ability of the central bank to deal with unexpected events such as a financial crisis- this means expansionary policy is needed which would lead to high inflation

4. finding an appropriate inflation target- what is the right level in a particular situation

5. difficulties of implementation- inflation targeting is based heavily on forecasts of future inflation and economic activity and forecasts are often highly unreliable

Strengths of monetary policy:

1. relatively quick implementation

2. central bank independence

central bank can take decisions that are in the best longer term interest of the economy and therefore exercises greater freedom in pursuing policies that may be politically unpopular

3. no political constraints

no budget constraints

4. no crowding out

5. ability to adjust interest rates incrementally (in small steps)

Weaknesses of monetary policy:

1. time lags

2. possible ineffectiveness in recession

3. conflict between government objectives

(conflict in using interest rates-> inflation vs exchange rate policy)

4. inability to deal with stagflation

5. liquidity trap

the interest rates are already so low, near zero that any further reduction may not be effective