3.5 - Demand management - monetary policy

what are the demand-side policies

- monetary policy (cut interest rates)

- fiscal policy (cut tax rates)

- devaluation (reduce value of currency)

- quantitative easing (increasing money supply)

what are the supply-side policies

- privatisation/deregulation

- investment in education/training

- more flexible labour markets

- reduced tax rates

- reduced power of trade unions

demand-side policies/demand management

shifting the AD curve in the AD-AS model to bring AD to potential GDP.

what idea are demand-side policies based on

short-term fluctuations in real GDP of the business cycle are due to actions of firms and consumers affecting aggregate demand, causing inflationary or deflationary/recessionary gaps.

two types of demand-side policies

- monetary policy

- fiscal policy

goal of monetary and fiscal policies

reduce instabilities caused by the short-run fluctuations of AD in the business cycle. called stabilisation policies

supply-side policies

focus on factors aimed at shifting the LRAS/Keynesian AS curves to the right, to increase potential output and achieve long-term economic growth.

supply-side policies do not stabilise the economy through...

reducing the fluctuations of the business cycle

how do supply-side policies stabilise the economy?

they increase the quantity and quality of factors of production, as well as on institutional changes intended to improve the economy's productive capacity

two major categories of supply-side policies

market-based, interventionist

who is the monetary policy carried out by?

the central bank of each country

commercial banks

financial institutions which may be private or public sector organisations

commercial banks functions

- hold deposits for customers

- make loans to customers, transfer funds from one bank to another

- buy government bonds

central banks

government financial institutions

central banks functions

- Acts as banker to the government (manages cash, payments, borrowing, financial advice)

- Acts as banker to commercial banks (holds deposits, lends when needed)

- Regulates and supervises commercial banks to ensure stability

- Conducts monetary policy (controls money supply, interest rates, and influences exchange rates)

advantage of central banks' independence from government interference

monetary policy can be conducted with a view to what is considered to be in the best longer-term interests of the economy without interference from political pressures

goals of monetary policy

- low and stable rate of inflation

- low unemployment

- reduce business cycle fluctuations (short-run)

- promote a stable economic environment for long-term growth

- external balance

inflation targeting

the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets

advantages of inflation targeting

- lower, more stable rate of inflation

- anticipate future rate of inflation -> reduces uncertainty in decision making

- better coordinate fiscal policy to complement monetary policy

- greater central bank transparency and accountability via increased communication with public

disadvantages of inflation targeting

- reduced ability to pursue other macroeconomic objectives (full employment GDP, exchange rate stability)

- reduced ability to respond to supply-side shocks

- reduced flexibility to bring economy out of recession (higher inflation rate than target)

- reduced ability to deal with unexpected events

- Determining appropriate inflation target

- implementation difficulty as based on forcast

money supply and rate of interest relationship

an increase in the supply of money leads to a fall in the rate of interest; a decrease in the supply of money leads to an increase in the rate of interest

The central bank can conduct monetary policy through controlling...

the money supply or the rate of interest

monetary policy tools

- open market operations

- minimum reserve requirements

- central bank minimum lending rate

- quantitative easing

open market operations (OMO) to lower interest rate

buy bonds -> increase commercial bank reserve & money supply

open market operations (OMO) to increase interest rate

sell bonds -> decrease commercial bank reserves & money supply

minimum reserve requirements to lower interest rate

lower minimum reserve requirements -> increase commercial bank reserves & money supply

minimum reserve requirements to increase interest rate

increase minimum reserve requirements -> decrease commercial bank reserves & money supply

central bank minimum lending rate to lower interest rate

lower minimum lending rate -> increase commercial bank reserves & money supply

central bank minimum lending rate to increase interest rate

increase minimum lending rate -> decrease commercial bank reserves & money supply

quantitative easing to lower interest rate

create new reserves electronically used by the central bank to buy a huge variety and quantity of assets to directly increase the money supply

when is quantitative easing used

only when interest rate is already low and to decrease it further. its a non-conventional monetary policy used as a last resort (e.g. covid)

changes in interest rates affect what components of aggregate demand?

investment (I), and consumption (C)

how is investment (I) affected by changes in interest rates?

changes in interest rates affect the amount of borrowing by businesses to finance their investment expenditures

how is consumption (C) affected by changes in interest rates?

since some consumer spending is paid for out of borrowing, a change in interest rates is intended to affect the amount of consumer spending

an increase in interest rates is intended to...

lower consumer and business borrowing and hence spending (lower C and I), and therefore shift AD to the left

a decrease in interest rates is intended to...

increase consumer and business borrowing and hence spending (higher C and I), and therefore shift AD to the right

expansionary (easy) monetary policy

demand side policy to correct recessionary gap

what does expansionary (easy) monetary policy do to money supply and interest rate?

increase supply of money, lower interest rate

what does expansionary (easy) monetary policy result in?

increased consumption and investment spending -> increased AD

contractionary (tight) monetary policy

demand side policy to correct inflationary gap

what does contractionary (tight) monetary policy do to money supply and interest rate?

decrease supply of money, raise interest rate

what does contractionary (tight) monetary policy result in?

decreased consumption and investment spending -> decreased AD

nominal interest rates

the market rate that prevails at any moment in time

real interest rates

the interest rate that has been corrected for inflation

real interest rate formula

real interest rate = nominal interest rate - rate of inflation

strengths of monetary policy

- relatively quick implementation (doesnt have to go through political process unlike fiscal)

- central bank independence (make best decisions for economy long-term)

- no political constraints

- no crowding out (lower, not higher interest rates)

- ability to adjust interest rates incrementally

weaknesses of monetary policy

- time lags (changes in interest rates may take several months to take effect. economic conditions may have changed)

- possible ineffectiveness in recession (banks may be unwilling to increase lending)

- conflict between government objectives (affects foreign sector e.g. exchange rates)

- inability to deal with stagflation (demand-side policy unable to deal with supply-side causes of instability)