Monetary policy

Monetary policy use of interest rates and money supply in order to influence the level of AD and economic activity it aims to achive the macroeconomic objectives.

Central bank is responsible for implementing the monetary policy and regulating the financial system. It controls the money supply and set the interest rates. Regulates the banking system. Before making some changes the central bank consider the expected level of economic activity, the level of inflation rate and outlook of the global economy.

Money supply is the total amount of money in the circulation.

Interest rates could changed by 0.5% during a month.

A demand side policy - governemnt strategy to influence the level of AD.

Goals of monetary policy:

  • low and stable inflation - inflation rate target/ targeting refers to the practise of central bank in some countries (Canada, Finland, New Zealand) use of monetary policy to achieve a specific rate of inflation. Price stability will enhance consumer and business confidence in the economy.
  • low unemployment - role of government to achieve full employment. Lower interest rates can influence the level of consumption that boost the level of AD. As national output increases this should reduced the level of unemployment.
  • reduce the business cycle fluctuations - lower interest rates can be used during economic downturn to influence consumption and therefore level of AD. However, if the economy is booming higher interest rates will reduce the impact of inflationary pressures.
  • promote a stable economic environment for long-term growth - effective ues of monetary policy by stabilizing the business cycle fluctuations, will helps to encourage investments for long-term growth in the economy.
  • external balance - value of countrys export earnings that are roughly equal to value of import expenditure. Interest rates can be used to influence exchange rates. Lower interest rates will make the currency less attractive for foreging buyers so it will reduce the exchange rate and will increase the demand for exports. Export earning> imports expenditure and this inflationary pressure inject more money to domestic economy. The opposite situation create negative external balance and its a net outflow of money from the economy.

Nominal interest rates is the actual rate that bank and customer agreed on. It is the rate borrowers pay on their loans.

The real interest rates accounts on the impact of the inflation.

Real interest rates = Nominal interest rates - Inflation rate

Negative real interest rate - when the inflation rate is greater than the nominal interest rate, any return on savings are dimnished by the effect of higher prices.

Expansionary monetary policy - boost economic activity by ==expanding the money supply==. By ^^lowering interest rates^^ to stimulate the AD by closing a deflationary gap. Consequence of this monetary policy is potential inflationary pressure.

Contraction monetary policy - reduces the level of economic activity by restricting the money supply therefore rising the interest rates and surpress AD and closing the inflationary gap.

Effectivness of monetary policy:

  • limited scope of reducing interest rates - for example Japan have interest rates close to zero since 1990 (2018 indicates 0.30%) this monetary policy do not take the country from the recession.
  • low consumer and business confidence - prolonged economic recession. Unstable economic situation will prevent firms and consumers to invest.
  • incremental, flexible and easily reversible - policymakers can monitor how change in interest rates affect the economy. They can change their decision realy quickly so they are reversible and flexible at once.
  • short time lags - it takes relatively small amount of time to implement an interest rates an see how they affect the economy. England during covid cut the interest rates twice within the week in order to stablize the economic downturn.