Monetary policy (Interest rate policy)

How does expansionary monetary policy of lowering interest rate work?

Expansionary Monetary Policy (Cheap or Loose Monetary Policy)

The central bank increases money supply to lower interest rate to make credit more easily available and borrowing cheaper. 

Expansionary monetary policy is typically implemented during economic slowdown/recession to increase real national income and lower cyclical unemployment. Also, to raise deflation.

(Internal effects of interest rate) A fall in interest rate lowers the cost of borrowing. Households are more likely to borrow to purchase big-ticket items or consumer durables such as cars, furniture and household appliances. The opportunity cost of spending is low. At the same time, households are also less incentivized to save as the rewards from saving has decreased. As a result, consumption spending (C) rises. For firms, there will be more projects which will now be profitable due to the lower cost of borrowed funds used to finance these projects. With more projects undertaken, there will be increased investment (I) in plants and machines. The increase in C and I will lead to an increase in aggregate demand in the economy. This leads to a multiplied increase in real GDP. (Explain the short multiplier process).  An injection or autonomous increase in expenditure will generate income for individuals employed by firms in the capital goods industry. These individuals will spend a proportion of the additional income on consumption, depending on their marginal propensity to consume (MPC). This spending further creates income for individuals employed in the consumer goods industry who will further spend their additional income on consumption. This cycle of spending and re-spending on consumption will continue. The eventual increase in the real national income is several times the initial increase in expenditure. Actual Growth rises in the short run. The rise in investment increases the capital accumulation / capital stock of the economy, and the productive capacity rises leading to rise in LRAS; potential growth in the long run. This helps the Singapore economy to get out of the recession. (If question asks how fiscal policy raises standard of living, have to add in material and non material standard of living here)

As domestic production rises, more jobs are created. Demand for labour  rises since demand for labour is a derived demand. More workers are employed, hence reducing cyclical unemployment.

(External effect of interest rate) The fall in domestic interest rate, ceteris paribus, will mean that the interest rate in the country falls relative to that of other countries. In an open economy where capital (financial) flows are unrestricted across countries, there will be an outflow of hot money or short term funds from the country in search for higher interest rates in other countries. This increases the supply of the country’s currency in the foreign exchange market. At the same time,the fall in domestic interest rate will lead to a decrease in the inflow of hot money to the country, whose interest rate has fallen. This reduces the demand for the country’s currency. In a free/managed float exchange rate regime, the result is a depreciation of the country’s currency against other currencies.

Explain how the above depreciation affect net exports:

With the depreciating exchange rate, the country’s exports are now cheaper in foreign currency (i.e., price of exports in foreign currency falls) resulting in an increase in amount of exports. At the same time, imports become more expensive (i.e., price of imports in local currency increases), resulting in a fall in amount of imports. An increase in the amount of exports and a fall in the amount of imports results in an increase in net exports, contributing to an increase in aggregate demand. (RI lecture notes version)

OR

Depreciation makes the price of exports relatively cheaper in foreign currency and price of imports relatively more expensive in the domestic currency. Assuming Marshall-Lerner condition, where PEDx + PEDm >1, a fall in price of exports lead to a more than proportionate rise in quantity demanded for exports, and a rise in price of imports lead to a more than proportionate fall in quantity demanded for imports. There is a rise in export revenue and a fall in import expenditure respectively. This leads to a rise in net exports (X-M).  The increase in C and I will lead to an increase in aggregate demand in the economy. This leads to a multiplied increase in real GDP. (Explain the short multiplier process).  An injection or autonomous increase in expenditure will generate income for individuals employed by firms in the capital goods industry. These individuals will spend a proportion of the additional income on consumption, depending on their marginal propensity to consume (MPC). This spending further creates income for individuals employed in the consumer goods industry who will further spend their additional income on consumption. This cycle of spending and re-spending on consumption will continue. The eventual increase in the real national income is several times the initial increase in expenditure. Actual Growth rises in the short run. The rise in investment increases the capital accumulation / capital stock of the economy, and the productive capacity rises leading to rise in LRAS; potential growth in the long run. This helps the Singapore economy to get out of the recession. (If question asks how fiscal policy raises standard of living, have to add in material and non material standard of living here)

As domestic production rises, more jobs are created. Demand for labour  rises since demand for labour is a derived demand. More workers are employed, hence reducing cyclical unemployment.

Take note: 

Depreciation makes it cheaper for foreign investors (Firms/MNCs) to invest in the country and makes it more expensive for domestic investors to invest in other countries. Long-term capital inflow rises. Long-term capital outflow decreases. (This improves the capital and financial account balance position.) Overall, net FDI inflow. AD rises……

What are the evaluation/limitation of using expansionary monetary policy of lowering interest rate

Evaluation:

1. (If a question requires you to use both expansionary fiscal and monetary policy, reserve size of multiplier to evaluate EFP.) The extent of the rise of the real national income is limited by the size of the multiplier. If the multiplier is small, then the rise in national income is small. If the multiplier is large, then the rise in national income is large. In turn, the size of the multiplier depends on the size of the withdrawals. If withdrawals are large, then the multiplier is small. If withdrawals are small, then the multiplier is large. For example, Singapore has a small multiplier due to high MPM and high MPS. High MPM is due to the small and open economy and the lack of natural resources. This means Singapore is highly dependent on imports for domestic production and consumption. The high MPS is due to the large pool of savings in the form of compulsory Central Provident Fund. Therefore, Singapore’s small multiplier implies that when the government adopts expansionary monetary policy, the rise in RNY is insignificant.

On the other hand, the US has a large multiplier because MPC is large as consumption contributes more than 70% to GDP. This means when the US government adopts EMP, the extent of the rise in real national income is larger. Hence, EMP is more effective in the US than in Singapore. The small size of SG multiplier explains why monetary policy is ineffective in Singapore, as such, Singapore’s monetary policy is centered around the exchange rate. 

2.       (Compulsory) (Reserve for monetary policy)  Even though interest rates fall, C and I may not rise because C and I may be interest-inelastic. Consumption and investment are more dependent on business expectations or what John Meynard Keynes called animal spirits. When the business outlook is pessimistic such as during a recession, consumers’ and firms’ and businesses’ confidence are low. So even if interest rates fall, it may not lead to a rise in C and I. So AD may not rise.

The MEI curve could be interest-inelastic if a large proportion of an economy’s investments is funded by foreign direct investment (FDI). FDI is the flow of funds from external sources into a country for the purpose of acquiring capital goods (i.e., equipment and factories). As foreign MNCs have their own sources of funds and may not borrow from the local banks, a fall in the host country’s interest rate have little bearing on these foreign MNCs decision to bring their funds into the host country for investment purpose. In this instance, the impact of the interest rate may be limited. Thus, expanding the money supply to lower the interest rate may not have as significant an impact on investment if the demand for investment is interest-inelastic.

3. Liquidity Trap

At very low levels interest rates, the demand for money becomes perfectly interest elastic. This extreme region is known as a liquidity trap where an increase in the supply of money will not have any effect on the rate of interest because it is difficult for the interest to fall below zero. Thus, the level of aggregate demand and real national output will remain the same. Under such circumstances, monetary policy of increasing money supply to decrease interest rate will be ineffective.

OR

There may be a liquidity trap. This means interest rates are already so low that they cannot possibly go lower. Eg. Between 2008 - 2019, interest rates in the world were low.

“There is a lower bound for interest rates (zero) and hence a limit to how far interest rates can fall. Nominal interest rates cannot fall below zero because this indicates that an individual who saves is effectively being charged to deposit his/her money in the bank. In this case, individuals would rather just hold cash (money) which is more liquid³ than savings.

When interest rates are already very low, i.e. almost or at zero, expansionary monetary policy may no longer be effective. This situation is called a liquidity trap. Any rise in money supply to reduce interest rates will only result in the extra liquidity being kept in idle balances as firms and households are unwilling to spend. In this environment, aggregate demand, production, and employment may be “trapped” at low levels, and expansionary monetary policy loses its effectiveness in boosting AD.”

4. Time lags between implementation and impact on the economy

Due to time lags of the multiplier effect, it can take a fairly long time for a monetary policy to affect the economy. For example, the multiplied effect on real national output can take anywhere from three months to two years to be completed. As a result, an interest rate cut may be less effective in increasing real national income and decreasing unemployment in the near term.  Instead, it may take effect at the time (over the longer term)  when  economic  recovery  is  already  underway.  In  such  an  instance,  the expansionary monetary policy may cause unintended demand-pull inflation. 

5. Unintended consequences: 

1. Conflict of objectives

Expansionary monetary policy aims to increase level of real national income and lower unemployment level. However, it can also bring about higher rates of inflation as GPL rises, especially  when it is implemented in an economy operating in the intermediate range of the AS curve (i.e. limited spare capacity).

2. The use of quantitative easing had been responsible for recent asset price inflation.

An asset (property and shares) bubble occurs when the market price of an asset exceeds its rightful price.

Lower interest rates reduce costs of borrowing, which boosts investment spending. Thus, investors invest in various types of assets, spiking asset prices.

The accelerated increase in asset prices attracts many to borrow and invest. However, when the asset prices eventually fall when the bubble bursts, many then suffer huge losses and incurs high debts, leading to serious recessionary pressures and economic hardships.

Through the widespread purchases of financial assets, the US Federal Reserve and Bank of England had injected massive amount of funds into the financial sector causing stock prices to increase over time. Moreover, the long-term commitment to low interest rates also fuelled increases in property prices worldwide since it reduced the cost of borrowing significantly. Cheaper to borrow and buy property. Since assets are usually held by the wealthier segments of the population, quantitative easing had also played a part in widening income inequality. 

What are the strengths and weaknesses of monetary policy?

Strengths of monetary policy (note: expansionary montery policy aka loose/easy monetary policy. Contractionary monetary policy aka tight monetary policy)

1. Relatively quick implementation. Monetary

policy  can be implemented more quickly than

fiscal policy  because it does not have to go through the political process, which  is very 

cumbersome and time consuming, though monetary policy is subject to some time lags, central banks can react swiftly to economic changes by adjusting interest rates, which directly affects borrowing costs and investment. This is due to central bank independence, which means the

central bank can take decisions that are in the best

longer term interests of the economy, and therefore

exercises greater freedom in pursuing policies

that may be politically unpopular such as higher

interest rates making borrowing more costly.

2. No political constraints. Even if a central bank

is not independent of the government, monetary

policy is still not subject to the same kinds of

political pressures as fiscal policy, since it does not

involve making changes in the government budget,

whether in terms of government spending that

would affect merit and public goods provision, or

government revenues (taxes).

3. Ability to adjust interest rates incrementally

(in small steps). Interest rates can be adjusted

in very small steps, making monetary policy

better suited to ‘fine tuning’ of the economy in

comparison with fiscal policy. However, it should

be stressed that it is also subject to limitations, and

that there is in fact no policy tool that economists

can use to fully ‘fine tune’ an economy.

Whereas fiscal policy can lead the economy in a general

direction of larger or smaller aggregate demand,

it cannot ‘fine tune’ the economy; it cannot be

used to reach a precise target with respect to the

level of output, employment and the price level. If

fiscal policy were successful, it would be possible

to use it to keep the economy’s real GDP at or

very close to its potential output level. However,

experience has shown that this cannot be done,

as there are many factors affecting aggregate

demand simultaneously that the government

cannot control.

Weaknesses of monetary policy

1. Time lags. Unlike fiscal policy, monetary policy can

be implemented and changed according to perceived

needs relatively quickly, because it does not depend

on the political process. However, like fiscal policy,

it remains subject to time lags (delays), including a

lag until the problem is recognised, and a lag until

the policy takes effect. Changes in interest rates can

take several months to have an impact on aggregate

demand, real output and the price level. By then,

economic conditions may have changed so that the

policy undertaken is no longer appropriate.

2. Possible ineffectiveness in recession. Whereas

monetary policy can work effectively when it

restricts the money supply to fight inflation, it is

less certain to be as effective in a deep recession.

Expansionary monetary policy is intended to

increase aggregate demand by encouraging

investment and consumption spending through

lower interest rates. This process presupposes that

banks will be willing to increase their lending to

firms and consumers, and that firms and consumers

will be willing to increase their borrowing and their

spending. However, in a severe recession, banks may

be unwilling to increase their lending, because they

may fear that the borrowers might be unable to repay

the loans. If firms and consumers are pessimistic

about future economic conditions, they may avoid

taking out new loans, and may even reduce their

investment and consumer spending, in which case

aggregate demand will not increase (it may even

decrease), and monetary policy will be unable to pull

the economy out of recession. This is not something

that happens often; however, it appears to have

occurred during the Great Depression of the 1930s,

in Japan in the late 1990s and early 2000s, and in the

global recession that began in the autumn of 2008.

3. Inability to deal with stagflation. Monetary

policy is a demand-side policy, and is therefore

unable to deal effectively with supply-side causes of

instability, just like fiscal policy.

FP has an inability to deal  with supply-side causes of instability. If instability is caused by supply- side factors, leading to stagflation, where there is falling real GDP and inflation simultaneously (see page 281), fiscal policy  is unable to deal with it effectively.  Inflation requires a contractionary policy,  while  the recession requires an expansionary policy.  A contractionary policy  could  address the problem  of inflation, but would  make the recession worse; an expansionary  policy could help get the economy out of recession, but would  worsen the problem of inflation.

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