3.10 - demand side policies -> monetary policy

demand-side policies (demand management)

focus on

• changing aggregate demand

• shifting the aggregate demand in the AD AS diagram

to achieve macroeconomic goals

to counteract the effects of economic fluctuations and bring AD to the full employment level of rGDP

types of demand side polcies (2)

stabilization policies

• monetary policy

• fiscal policy

*attempt to reduce the short-term fluctuations of the business cycle

**eliminating short term instabilities caused by increases/ decreases of AD

***in theory: business cycle would flatten out and economys rGDP would be very close to Yp (potential output)

****in practice: the most they can do is lessen the severity of business cycle

monetary policy

• central banks

• to control the money supply and interest rates

• in order to manage economic stability and influence aggregate demand.

commercial bank

financial institutions that are to

• hold deposits

• make loans

• transfer funds

• buy government bonds

for their customers

central bank

a government financial institution with several important responsibilities

• although being a governmental institution it has a degree of independence

  • it ensures that monetary policy can be conducted in the best long-term interest of the economy

  • without interference from political pressure

central bank responsibilities

• banker to the government

• banker to commercial banks

• regulator to commercial banks

• conduct monetary policy

goals of the monetary policy

• low and stable rate of inflation (~2%)

• low unemployment

  • controling cyclical unemployment during deflationary gap

• reduce business cycle fluctuations

• promote a stable economic environment for long-term growth

• external balance

  • balance between exports revenue and imports spending

inflation targeting

monetary policcy framework that aims to

• maintain a specified level of inflation, typically around a target rate,

  • to promote economic stability and predictability.

advantages of inflation targeting

• achievement of low and stable rate of inflation

• improved ability of economic decision-makers to anticipate future fluctuations

• greater co-ordination between monetary and fiscal policy

  • knowledge about inflation targets allows government to plan fiscal policies

disadvantages of inflation targeting

• reduced ability of the central bank to pursue other macroeconomic objectives

  • eg. full employmeny

• reduced ability of the central bank to respond to supply-side shocks

  • in order to control cost-push inflation and stagflation it may have to sacrifice its inflation goal in some situations

• a too low target may lead to higher unemployment

interest rate

a percentage of the amount borrower charged by a lender to a borrower for the use of funds on top of the normal payment

supply of money (Sm)

the total amount of monetary assets available in an economy at a specific time

• fixed level decided upon by the central bank

  • it is a vertical line as it doesn’t depend on the rate of interest

• changing the money supply is to influence AD

demand for money (Dm)

• interest rates fall = increase in holding money demanded by the public

*the higher the interest rate the less attractive it is for you to hold money, and better off to put into banking account that earns interest

**money itself doesn’t earn interest

shift of Sm

• if central changes the money supply Sm curve shifts

  • this determines a new rate of interest

    • demand for holding money increases

setting a target interest rate

• central bank sets a target interest rate it wants to achieve

  • then takes steps to adjust the money supply so that the actual equilibrium interest rate will become equal to the target interest rate

minimum reserve requirement/ required reserve ratio

funds that the central bank must legally keep, which are a fraction of total deposits

excess reserves

funds that banks hold beyond the required reserve ratio, which can be used for lending and investing.

monetary multiplier

monetary multiplier = 1 / required reserve (as a percentage of deposits)

fractional reserve system → amount of new loans/ new money created

monetary multiplier x excess reserves

*it is the maximum amount that can be created, it may not necessarily be actually that much

EXAMPLE

Person A deposits a 1000 in a bank

the minimum reserves requirement = 20%

so

200$ stays as the required reserve

and 800$ circulates

Person B borrows that 800$ and buys a good from Person C

Percon C deposits that 800$ in the bank, but bank keeps the 20%

so 160$

and 640$ continues to circulate

…..

new money created = (1 / 0.20) x 800$ = 4 000$

tools of monetary policy to influence the supply of money

• open market operations

• minimum reserve requirements

• changes in the central bank’s minimum lending rate

• quantitative easing

open market operations

operations by use of bonds (debts)

to lower the interest rate (increase money supply) the central bank will:

• buy government bonds from commercial banks

  • increase excess reserves in commercial bank

  • ability to make more loans

  • thus increasing money supply

to increase the interest rate (decrease money supply) the central bank will

• sell government bonds from commercial banks

  • decrease excess reserves in commercial bank

  • ability to make less loans

  • thus decreasing money supply

minimum reserve requirement

changing minimum reserve requirements by the central banks

to lower the interest rate (increase money supply) the central bank will:

• lower minimum reserve requirements

• increasing excess reserves in commercial banks

• thus increasing money supply

to increase the interest rate (decrease money supply) the central bank will:

• increase minimum reserve requirements

• decreasing excess reserves in commercial banks

• thus decreasing money supply

changes in the central bank’s minimum lending rate

minimum lending rate = the interest rate at which the central bank lends to commercial banks.

to lower the interest rate (increase supply of money) the central bank will:

• lower minimum lending rate

• higher commercial bank excess reserves

• thus increasing money supply

to increase the interest rate (decrease supply of money) the central bank will:

• increase minimum lending rate

• lower excess reserves in commercial banks

• thus decreasing money supply

quantitative easing

non-traditional type of monetary policy

• central banks buy huge quantities of assets that commercial banks have or own

• to pay for those assets central bank creates reserves electronically for the commercial banks

  • commercial banks end up with many more reserves which they can use to make a lot of loans, increasing AD

to lower the interest rates (increase money supply) the central bank will:

• create new reserves electronically

• increased excess reserves in commercial banks

• increased money supply

nominal interest rate

the stated interest rate before adjustment for inflation.

real interest rate

the nominal interest rate adjusted for inflation, reflecting the true cost of borrowing and the true yield to lenders.

real interest rate = nominal interest rate - rate of inflation

effect of changing interest rates/ money supply on AD

• effect on

  • investment

  • consumprion

higher interest rate = more saving = less consumer and business borrowing/ spending = left shift of AD (fall)

lower interest rate = less saving = more consumer and business borrowing/ spending - right shift of AD (increase)

expansionary monetary policy

increase in the money supply by the central bank

• to expand AD

• in case of a deflationary gap

*with demand for money constant interest rate falls from i1 to i2

• lower cost of borrowing

• consumer and businesses more likely to borrow and spend more

• increased (right shift) of AD

contraction monetary policy

decrease in money supply by central bank

• to decrease AD

• to mitigate inflationary gap

*with demand for money constant interest rate rises from i1 to i3

• higher cost of borrowing

• consumer and businesses more likely to borrow and spend more

• increased (right shift) of AD

Ratchet effect on the keynesian model of contractionary monetary policy

ratchet effect

• the price level moves up when there is an increase in AD and then remains at the same level until there is further increase in AD

• when AD falls price stay constant and Yinfl falls to Yp

• more realistic representation of what happens in real world

constrains on monetary policy

• possible ineffectiveness in recession

  • interest rates cannot fall when approaching zero

  • low consumer and producer confidence

  • banks may be fearful of lending

• conflict between government objectives

  • domestic objectives may conflict with foreign sector objectives

• may be inflationary

  • when the policy lasts too long it may push the AD over the necessary value to eliminate a deflationary gap

• unable to deal with stagflation or cost push inflation

strengths of monetary policy

• interest rate changes can be gradual

• interest rates changes are reversible

• monetary policy is flexible

• relatively short time lags

  • days for the change to apply

• central bank independence

• limited political constraints

  • as it doesn’t involve making changes in the government budget

• no budget deficit or debt

• no crowding out