Monetary Policy and Demand Management

Flashcards covering key concepts related to monetary policy, demand management, and money creation by commercial banks.

What is monetary policy?

The government's use of interest rates and the money supply to influence the level of aggregate demand and economic activity.

What are the goals of monetary policy?

Low and stable rate of inflation, low unemployment, reduce business cycle fluctuations, promote a stable economic environment, and external balance.

What is the difference between nominal and real interest rates?

Nominal interest rate is the headline rate, while the real interest rate is the nominal interest rate minus the rate of inflation.

How is the real interest rate calculated?

Real Interest Rate = Nominal Interest Rate - Inflation

In the equilibrium interest rate diagram, why is the supply of money a vertical line?

Unlike goods and services, the market will not supply more money in times of high demand; the money supply is fixed by the central bank.

How does an expansionary monetary policy affect the supply of money and interest rates?

It shifts the supply of money to the right, increasing the money supply in circulation and lowering interest rates.

How does an increase in aggregate demand components affect the demand for money and interest rates?

It increases the demand for money, which in turn increases interest rates.

What are Open Market Operations (OMOs)?

The buying and selling of government bonds by the central bank to influence the money supply.

How does the central bank selling bonds affect the money supply and interest rates?

It reduces the money supply, increasing interest rates and reducing inflation.

How do minimum reserve requirements influence the amount of money banks can lend?

By setting a minimum reserve requirement, banks are obliged to keep a certain amount of customer deposits safe, decreasing the amount of money lent out.

How do changes in the central bank minimum lending rate affect commercial banks and borrowing costs?

If the central bank increases this interest rate, commercial banks have a higher cost of borrowing money, which they offset by raising their interest rates, making borrowing more expensive for households and firms.

What is quantitative easing?

Buying and selling of bonds on a larger scale than OMOs, typically involving riskier bonds, when the central bank base interest rate is very low.

What actions are involved in an expansionary monetary policy?

Decrease minimum reserve ratio, decrease the central bank interest rate, buy government bonds, and buy corporate bonds (quantitative easing).

What is the effect of expansionary monetary policy on AD?

Lower interest rates cause investment and consumption to increase, leading to an increase in aggregate demand.

What actions are involved in contractionary monetary policy?

Increase minimum reserve ratio, increase the central bank interest rate, and sell government bonds.

What is the effect of contractionary monetary policy on AD?

Higher interest rates cause investment and consumption to decrease, leading to a decrease in aggregate demand.

What are the strengths of monetary policy?

Incremental, flexible, easily reversible, and short time lags.

What are the weaknesses of monetary policy?

Effectiveness decreases when interest rates are close to 0 and low consumer and business confidence.

How do commercial banks create credit?

By lending out deposited money to borrowers, who then deposit this loan into another bank, which can then lend that money out, creating more value in the economy.

What is the money multiplier formula?

Money Multiplier = 1 / Reserve Ratio

How does the minimum reserve ratio affect money creation by banks?

If the ratio increases, the amount of money banks can create decreases. If the ratio decreases, banks can lend out more money, creating more.