Monetary Policy and Central Banking - Theories & Tools

Vocabulary flashcards covering central banking theories, monetary policy concepts, and practical tools from the video notes.

Central Banking

The institution that manages a country's money supply, currency, and interest rates to pursue macroeconomic goals and provide financial stability, including acting as lender of last resort.

Gold Standard Rule

Central banks fixed exchange rates by backing currency with gold.

Lender of Last Resort

The central bank lends freely during crises to banks with good collateral to prevent panic and collapse.

Monetary neutrality

In the long run, changes in the money supply affect prices, not real output.

Classical theory of central banking

A passive, rule-bound approach focused on price stability.

Keynesian theory

An active approach where central banks manage the economy via interest rates and money supply to stabilize output and employment.

Aggregate demand management

Using monetary policy to influence overall demand and thus output.

Liquidity preference theory

Interest rates are determined by money demand and supply; policy can influence investment through rate changes.

Counter-cyclical policy

Policy that eases in recessions and tightens in booms.

Milton Friedman

Economist who advocated monetarist policy and rules-based control of the money supply.

Inflation is always and everywhere a monetary phenomenon

Friedman’s view that inflation primarily results from money-supply growth.

K% Rule

Money supply should grow at a constant rate in line with potential GDP.

Critique of Discretionary Policy

Discretionary policy can destabilize the economy due to lags and misjudgments.

Monetarist theory

Emphasizes controlling inflation through steady growth of the money supply and rules-based policy.

New Classical & Rational Expectations Theory

People form rational expectations; systematic policy is often ineffective; credibility matters.

Policy Ineffectiveness Proposition

Predictable monetary policy is already priced in; only surprises affect real output.

Time Inconsistency Problem

Policymakers may break promises (e.g., about low inflation) for incentives; credibility needed.

Credibility and commitment mechanisms

Independent central banks and inflation targeting to maintain credible policy.

New Keynesian theory

Combines rational expectations with price stickiness; supports rules-based yet flexible policy.

Taylor Rule

A systematic rule for setting interest rates based on inflation and output gaps.

Inflation Targeting

Central banks commit to a specific inflation rate to anchor expectations.

Modern Central Banking Practices (Post-2008)

Unconventional tools like QE, forward guidance, macroprudential regulation, and dual mandate.

Quantitative Easing (QE)

Purchasing long-term securities to inject liquidity into the economy.

Forward Guidance

Communicating future policy intentions to shape market expectations.

Macroprudential Regulation

Regulatory tools aimed at reducing systemic financial risks.

Dual Mandate

Policy goal of price stability plus maximum employment (e.g., U.S. Federal Reserve).

Modern Monetary Theory (MMT)

Sovereign currency-issuing governments can finance spending via money creation; inflation is the key constraint.

Monetary Sovereignty

Inflation, not budget deficits, is the main constraint for currency-issuing governments.

Fiscal dominance

When fiscal policy dictates central bank actions to accommodate government spending.

Quantity Theory of Money

MV = PQ; money supply times velocity equals price level times real output.

Velocity of money

The rate at which money circulates in the economy.

Money supply (M)

The total amount of money in circulation in the economy.

Price level (P)

The average level of prices of goods and services.

Real output (Q)

The actual quantity of goods and services produced.

Monetary policy transmission mechanism

Process by which policy actions affect interest rates, credit, and spending.

Open Market Operations

Central bank buys/sells government securities to influence money supply and rates.

Reserve requirements

The portion of deposits that banks must hold in reserve, affecting money creation.