3.5 Demand Management: Monetary Policy

Flashcards covering key vocabulary related to Demand Management and Monetary Policy, including definitions of various policies, interest rates, tools, and their effects on the economy.

Demand-side policies

Policies that aim to shift aggregate demand (AD) in an economy.

Fiscal policy

A demand-side policy that involves the use of government spending and taxation to influence aggregate demand (AD).

Monetary policy

A demand-side policy that involves adjusting interest rates and the money supply so as to influence aggregate demand (AD).

Goals of Monetary Policy

To achieve a low and stable rate of inflation, low unemployment, reduce business cycle fluctuations, promote a stable economic environment for long-term growth, and control the level of exports and imports (net external balance).

Nominal interest rate

The headline interest rate presented by commercial banks, which has not been adjusted for inflation.

Real interest rate

The nominal interest rate minus the rate of inflation.

Expansionary Monetary Policy (Loose Monetary Policy)

Monetary policy designed to generate further economic growth by reducing interest rates, increasing quantitative easing (QE), or depreciating the exchange rate; aims to shift aggregate demand (AD) to the right.

Aggregate Demand (AD)

The total demand for goods and services in an economy, calculated as household consumption (C) + firms' investment (I) + government spending (G) + exports (X) - imports (M).

Contractionary Monetary Policy (Tight Monetary Policy)

Monetary policy designed to slow down economic growth or reduce inflation by increasing interest rates, decreasing/stopping quantitative easing (QE), or appreciating the exchange rate; aims to shift aggregate demand (AD) to the left.

Fractional-reserve banking (Money Creation Process)

The process by which commercial banks create money through a cycle of lending and deposit creation, where an initial deposit is multiplied by successive rounds of borrowing and deposits.

Reserve Requirement

The minimum percentage of customer deposits that commercial banks are required by the Central Bank to hold as reserves.

Open Market Operations

A monetary policy tool involving the buying and selling of government securities (e.g., bonds) by the Central Bank in the open market, typically with commercial banks, to influence the money supply.

Minimum Reserve Requirements

Regulations set by the Central Bank that specify the minimum percentage of customer deposits commercial banks must hold as reserves, often in the form of cash or deposits with the Central Bank.

Reserve Ratio

The percentage of customer deposits that banks must hold as reserves, specified by the Central Bank.

Base Rate (Official Rate)

The interest rate at which the Central Bank lends money to commercial banks, serving as a benchmark for general interest rates in the economy.

Transmission Mechanism (Monetary Policy)

The ripple effect created throughout an economy by changes to the base rate, involving a series of steps that result in a specific economic outcome.

Quantitative Easing (QE)

An unconventional monetary policy tool where Central Banks create new electronic reserves (digital money) to purchase government bonds, aiming to increase the money supply, lower long-term interest rates, and stimulate economic activity when traditional measures are less effective.

Strengths of Monetary Policy

Central Banks' independence from government, consideration of the long-term outlook, effectiveness in inflationary gaps, ability to target inflation and maintain stable prices, and the frequency and reversibility of policy alterations.

Weaknesses of Monetary Policy

Conflicting goals, less effectiveness during a deflationary gap or with large output gaps, potential lack of consumer response to lower interest rates due to low confidence, potential for asset price inflation, limitations on downward interest rate adjustments, and the risk of rapid inflation from QE.