3.5 Demand management (demand side policies)—monetary policy

Monetary policy

The manipulation of the money supply to influence interest rates in response to inflation

- Changes the supply of money in the economy in order to influence interest rates and exchange rates

- The central bank will seek to target an interest rate based on the changes in the money supply

-Continuously used to manipulate the economy → reaching a level of inflation the government thinks is appropriate

- Easier to implement and change

What does monetary policy target

Aims to change AD

Role of the central banks

Conducts monetary policy: Changing interest rates to increase or decrease inflation levels in the economy

Banker to the government

Banker to commercial banks

Creates legal tender (prints money)

Inflation

increase in the price level

- Decrease in the value of money

Goals of Monetary Policy

- Low and stable rate of inflation (inflation targeting)

- Low unemployment

- Reduce business cycle fluctuations

-Promote a stable economic environment for long-term growth

-Balance of payments (exports vs imports of currency)

Low and stable rate of inflation (inflation targeting)

The central bank will set a target inflation rate for the economy and use monetary policy to maintain that level of inflation

Low unemployment

Long-term: interest rates are tied to loans → Will people borrow or not?

Decreasing interest rates will lead to a lower cost of borrowing = greater business investment

Reduce business cycle fluctuations

Using interest rates to encourage or discourage consumer spending and business investment to reduce the fluctuations in the business cycle.

Promote a stable economic environment for long-term growth:

This leads to increasing confidence in the economy which should lead to greater investment and growth

Balance of payments (exports vs imports of currency)

If interest rates are high, then foreigners are more likely to make financial investments in a country because of a greater return on their investment. This leads to a greater demand for currency which leads to an appreciation of the currency.

Nominal vs. real interest rates (whats real interest rates)

Real interest rates are interest rates that take in inflation

-Interest rates can be fixed or adjusted to inflation

The role of Monetary policy:

Indirectly impacts people and businesses have to borrow money in response to the change and spend it to impact AD

Consumer spending: People borrow to consume

Investment spending: Businesses borrow to invest

Changing interest rates impacts the cost of borrowing and the benefit of saving

Tools of monetary policy HL (how does the central bank influence the money supply)

Open market operations (OMOs)

Minimum Reserve Requirements

Changes in the central bank minimum lending rate (base rate)

Quantitative Easing

Open market operations (OMOs)

The buying and selling of government bonds by the central bank

If the central bank sells bonds = and gets money while the buyer gets bonds → the central bank can lock this money up This reduces the money supply in the economy, increase interest rates and reduces inflation

- Contractionary policy

If the central bank buys bonds → gets bonds while the buyer gets money

- Will increase the money supply in the economy, decreasing interest rates and encouraging economic growth

- Expansionary policy

Minimum Reserve Requirements

Banks want to lend out as much money as possible, as they make more off of interest.

The more money is lent out, the more money is invested and consumed.

- a minimum reserve requirement = obliged to keep a certain amount of customer deposits safe (not lending them out/loans).

- decreases the amount of money lent out, indirectly decreasing I + C. (decrease in AD)

Changes in the central bank minimum lending rate (base rate)

Central banks of countries sometimes lend money out to commercial banks when they need it. If they increase this interest rate, commercial banks have a higher cost of borrowing money.

Commercial banks will offset this by raising their interest rates, making borrowing more expensive for households and firms.

- This decreases consumption and investment.

Quantitative Easing

Sometimes the central bank base interest rate is so low it can't go lower.

So what do they do when the economy is in need of expansion?

Quantitative Easing refers to the buying and selling of bonds, but on a larger scale (and more long-term) than OMOs.

- It is the same principle as OMOs, but the purchases are larger, and typically involve riskier bonds (corporate bonds instead of government bonds for exampl

Money Creation by Commercial Banks (HL) + formula

Money Multiplier = 1/Reserve Ratio

commercial banks need to create credit

- The bank can lend that money to the second borrow etc. (cycle)

- high minimum reserve ratio = multipler increases ( the amount of money banks can create decreases)

-lowest amount the commerical banks are required to keep as reserves in the central bank = limit how much they can lend and how much credit they can create

Low MMR = More money creation (lended) = More money = Cheaper borrowing = Cheaper investing = higher real GDP -> Vice versa

minimum Reserve ratio formula + example

Money Multiplier = 1/Reserve Ratio

eg. If a customer deposits $100 in a bank, the bank can lend that money out to someone else, charging interest for it

interest is returned to the original customer → the borrower now has money which they then deposit in a bank

Lowering base rate

-commerical banks can borrow reserves at a lower cost

- lower interest rates = more borrowing + more investments

Demand and Supply of Money - Equilibrium Interest Rates (graph)

equilibrium interest rate = supply is a vertical line unlike goods and services, the market will not supply more money in times of high demand.

- Demand of money: The total demand of money meant for spending

Supply of money: The total amount of money in circulation in an economy

Interest Rate on the y-axis

Quantity of Money on the x-axis

S and D can still change

Why is the money supply vertical and why is the demand going down

- inelastic because it is fixed

- it can change when the central bank wants to

- the demand is going down because of the liquidity of money

-> if interest rates are high = less liquidity (vice versa)

Shift in Demand of Money: draw decrease and increase in demand

If one of AD's components increases, there will be a general increase in the demand for money. This increases interest rates.

Shift in Supply of Money:

If the central bank uses one of its tools (OMO, minimum requirement reserve etc.) for expanding the economy (expansionary monetary policy), the supply will shift to the right, as there will be more money in circulation. This lowers interest rates.

Expansionary Monetary Policy: (easy monetary policy) (graph,explain and example)

In a recessionary gap the central bank lowers interest rates

-Makes the cost of borrowing less.

-Leads to an increase in business investment and consumer spending

-AD shifts right, RGDP increases and price level increases.

-The central bank will do this if inflation is too low or the economy is not producing at the full employment level of output

Eg.Following the Great recession in 2009, the UK lowered its interest rate to 1%. This became the interest rate for the next 10 years. When covid hit, the interest rate was reduced to virtually 0 = encourage spending while the economy was struggling

Contractionary monetary policy (tight monetary policy) (graph,explain and example)

In an inflationary gap, the central bank increases interest rates. This increases the cost of borrowing. This leads to a decrease in consumer spending and investment spending due to the increase in the cost of borrowing.

AD shifts left and the price level falls

Eg.

Following Covid, there has been a surge in demand creating demand-pull inflation but also an increase in the cost of production due to a slowdown in production during Covid = Bank of England increased interest rates incrementally but consistently over the last two years to 4.5 May 2023

The effectiveness of monetary policy (constraints)

1.Limited scope of reducing interest rates, when close to zero

2.Low consumer and business confidence

Limited scope of reducing interest rates, when close to zero (explain and example)

If the base interest rates are already at or close to zero then there is no more room for adjustment so there is no possibility for expansionary monetary policy to be applied

-Base rate: The central bank sets a rate other banks can borrow at before they let you borrow at a different rate

Eg. During the Great Recession, the Fed lowered interest rates to almost zero and they remained there until 2016

Low consumer and business confidence

Interest rates are indirect policies = they rely on consumers and businesses to spend in order to increase AD

If confidence is low = will not borrow money because the future is unclear. This means monetary policy will be effective.

Strengths:

1.Incremental, flexible and easily reversible:

2.Short time lags

Incremental, flexible and easily reversible:

The central bank can make small adjustments to interest rates every quarter. It can easily be adjusted with increases or decreases

- Incremental (small adjustments)

Short time lags

Interest rate adjustments are carried out by the central bank which is independent of the government. This means it can be quickly enacted.

-It still takes time to see the results as consumers and businesses have to take out loans and spend the money = much faster to implement than fiscal policy → central banks do not need to consult or get approval to make changes