Monetary policy

what is monetary policy

Easier version: Central bank controls the money supply and interest rate to influence the aggregate demand.

Exam version: Monetary policy is the use of changes in the money supply and interest rates by the central bank to influence aggregate demand and achieve macroeconomic objectives.

How does interest rate affect individuals consumption

When the interest rate is higher, which means that the cost of borrowing increases. Therefore, individuals are likely to reduce their consumption

How does the interest rate affect firms’ investment

When interest rates increase, the cost of borrowing for firms increases, making investment projects less profitable. Therefore, firms are likely to reduce investment.

What are the limitations of monetary policy

1. May not be effective during a recession

2. Conflict between government objectives

3. Problematic when dealing with stagflation or push-push inflation

What are the strengths of monetary policy

1. Interest rate changes can be incremental

2. Interest rate changes are reversible

3. Monetary policy is flexible

4. Relatively short time lags

5. Central bank independence

6. Limited political constraints

7. No crowding effect (HL)

8. No budget deficits or debt

Why monetary policy is not very effective during economical recession period

1. The interest rate is already approaching zero

2. Lower consumer and producer confidence

   1. If consumers or producers are not confident about future economic conditions, they may avoid taking out new loans and reduce their consumer spending and investment

3. Banks may fear lending

Goals of monetary policy

1. Low and stable inflation rate

2. Low unemployment

3. Reduced business cycle fluctuations

4. Promote a stable economic environment for long - term growth

5. External balance

What is external balance

Situations where a country’s revenue from exports is balanced by spending on imports over an extended period of time

What are the advantages of targeting inflation

1. Achieve low and stable inflation

2. Improve the ability of economic decision-makers to anticipate the future rate of inflation

3. Greater coordination between monetary and fiscal policy, since knowledge about inflation targets allows the government to plan its fiscal policy to complement the central bank’s monetary policy

What are the disadvantages of targeting inflation

1. Reduced ability of the central bank to pursue other macroeconomic objectives, e.g., the goal of full employment

2. Reduced ability of the central bank to respond to supply - side shocks

3. May lead to higher unemployment

What is the relationship between real interest rate and nominal interest rate

real interest rate = nominal interest rate - inflation rate