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 counteract the effects of economic fluctuations

types of demand side policies (2)

stabilization policies

• monetary policy

• fiscal policy

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

monetary policy

• set by 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 governmental financial institution with several important responsibilities

• has a degree of independence

  • 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 policy framework that aims to

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

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

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

  • to control cost-push inflation/ stagflation it may have to sacrifice its inflation goal

• a too low target may lead to higher unemployment

interest rate

a percentage of the amount borrower is charged by a lender 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 changes

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

(1/minimum reserve requirement )x excess reserves

*it is the maximum amount that can be created

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)

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

• * do opposite for decreasing money supply

minimum reserve requirement

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

• *do the opposite for 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

• *do the opposite to decrease supply of money

quantitative easing

• 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

• reflects the true cost of borrowing and the true yield to lenders

effect of changing interest rates/ money supply on AD

• affects

  • investment

  • consumption

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

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

• price moves up as AD moves up

• price stays constant as AD moves down

  • 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 governmental 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