3.5 Demand Management: Monetary Policy - IB Economics HL

Flashcards covering the essentials of monetary policy, demand-side policies, tools, transmission mechanisms, money creation, QE, and policy evaluation as presented in the notes.

What are the two categories of demand-side policies?

Fiscal policy and monetary policy.

What does fiscal policy involve?

The use of government spending and taxation to influence aggregate demand (AD). Governments usually present their annual budgets.

What does monetary policy involve?

Adjusting interest rates and the money supply to influence AD; central banks are usually responsible.

What are the main goals of monetary policy?

To achieve a low and stable inflation rate, low unemployment, reduced business cycle fluctuations, a stable environment for long-term growth, and a stable net external balance.

What is the nominal interest rate?

The headline rate quoted by banks, not adjusted for inflation.

What is the real interest rate?

The nominal interest rate minus the rate of inflation.

How do you calculate the real interest rate from CPI data?

Real rate = nominal rate − inflation rate.

What is expansionary monetary policy?

Policies to stimulate economic growth by increasing AD, such as lowering interest rates, increasing QE, or depreciating the exchange rate.

What is contractionary monetary policy?

Policies to slow growth or reduce inflation by decreasing AD, such as raising interest rates, reducing QE, or appreciating the exchange rate.

What is the AD identity used in the notes?

AD = C + I + G + (X − M) where AD is driven by changes in C, I, G, X, and M.

What is the impact of expansionary policy on AD and the price level in the typical diagram?

AD shifts to the right (AD → AD'), increasing real GDP (Y) and the average price level (AP).

What is the impact of contractionary policy on AD and the price level in the typical diagram?

AD shifts to the left (AD → AD'), reducing real GDP (Y) and the average price level (AP).

What is money creation via fractional reserve banking?

A process where banks lend out a portion of deposits, creating new money through multiple rounds of lending and deposits.

What are Open Market Operations (OMO)?

Central Bank purchases and sales of government securities in the open market to influence the money supply and interest rates.

How do Open Market Operations affect the money supply when the central bank buys bonds?

They inject money into the system by increasing bank reserves, expanding the money supply and often lowering interest rates.

How do Open Market Operations affect the money supply when the central bank sells bonds?

They withdraw money from circulation by reducing bank reserves, shrinking the money supply and often raising interest rates.

What are minimum reserve requirements?

Regulations requiring banks to hold a minimum fraction of deposits as reserves, affecting lending capacity and the money supply.

What is the effect of a higher reserve ratio on the money supply?

Banks have less money to lend, reducing the money supply.

What is the base rate (official rate)?

The central bank’s official rate at which it lends to commercial banks; used as a benchmark for other rates.

What is a transmission mechanism in monetary policy?

The process by which a change in the official rate affects the economy through channels like market rates, asset prices, exchange rates, net external demand, and inflation.

Give a simple expansionary transmission mechanism example.

Official rate decreases → market rates fall → loans are cheaper → consumption and investment rise → AD increases → inflation rises.

Give a simple contractionary transmission mechanism example.

Official rate increases → market rates rise → loan repayments more expensive → consumption falls → AD decreases → inflation falls.

What is Quantitative Easing (QE)?

An unconventional monetary policy tool where the central bank creates new electronic reserves and buys government bonds to inject money and stimulate activity, typically when rates are near zero.

What is the QE transmission mechanism?

Central bank purchases bonds → banks get more reserves → lending increases → aggregate demand (AD) rises → inflation rises.

What are the main strengths of monetary policy?

Independence from government, long-term perspective, ability to target inflation, and the ability to adjust 4–8 times per year.

What are the main weaknesses of monetary policy?

Conflicting goals with growth and inflation, less effective in a deflationary gap, dependence on confidence, the zero lower bound problem, and potential asset price inflation.

Why is monetary policy often faster to adjust than fiscal policy?

Monetary policy can be changed and reversed quickly (4–8 times per year); fiscal policy typically changes annually and is slower to implement.

What is the difference between open market operations and QE?

OMO use existing reserves to buy/sell government securities; QE creates new electronic reserves to buy assets, expanding the central bank’s balance sheet.

What is the purpose of QE in macroeconomics?

To increase the money supply, lower long-term interest rates, and encourage lending and investment when conventional policy is insufficient.

What is a key note about net external demand during expansionary policy?

Net external demand may worsen because higher price levels can raise imports and reduce exports.

What is the basic idea behind the examiner tips about policy timing?

Monetary policy can be adjusted more quickly than fiscal policy, but fiscal policy is often more predictable in its impact.