Macroeconomics: Monetary Policy

Question 1

Role of central bank

Answer 1

• banker to gov
• banker to commercial banks
• regulator of commercial banks
• conduct monetary policy

Question 2

Strengths of monetary policy

Answer 2

• Less time lag
• Central bank independence (no political constraints)
• No crowding out of investments
• Ability to adjust interest incrementally and flexibly

Question 3

Weaknesses of monetary policy

Answer 3

• may not be effective in deep recession - consumers and firms lack confidence in the economy, C and I remain unchanged; banks worry that borrowers cannot repay the loans and are reluctant to lend
• unable to deal with stagflation (only demand-side)

Question 4

Define monetary policy

Answer 4

Changes to interest rates, money supply and the exchange rate by the central bank in order to influence AD

Question 5

Why use monetary policy

Answer 5

Expansionary

• Increase demand-pull inflation
• Increase growth
• Reduce unemployment

Contractionary

• Reduce demand-pull inflation
• Prevent asset/credit bubbles
• Reduce excess debt and promote savings
• Reduce current account deficit

Question 6

Effects of expansionary monetary policy

Answer 6

Direct effects

• Lower credit card interest rates -> raise C
• Lower saving rates -> raise C
• Lower mortgage rates -> raise C
• Lower rates on business loans -> raise I
• Weaker exchange rate -> increase exports

Indirect effects

• lower rates on business loans -> raise I (improve in quantity/quality of capital, productive efficiency, boosts LRAS)

Question 7

Evaluate expansionary monetary policy

Answer 7

Cons

• Risk of demand-pull inflation
• Widen trade deficit
• Liquidity trap: interest rates have a lower bound, consumers and businesses already converted illiquid assets to liquid assets (bonds to cash) -> cutting interest rates further is ineffective, individuals already have hoards of cash to use for consumption/investment
• Negative impact on savers, living standards fall
• Time lags: time to realize the issue, time for policy to take effect

Evaluate

• size of output gap (Sections of the Keynesian model)
• consumer confidence
• business confidence
• banks willingness to lend (banking crisis, low financial security)
• size of the rate cut

Question 8

Evaluate contractionary monetary policy (raise interest rates)

Answer 8

Pros

• reduce demand-pull inflation
• discourage household/corporate debt
• more sustainable borrowing/lending -> less chance of asset price bubbles, less chance of recession
• encourage saving, safety net for households and businesses
• more affordable housing
• reduce current account deficit, less imports
• flexibility for expansionary monetary policy (space to decrease interest rates in the future)

Cons

• demand-side shock, discouraging C and I, lower growth, more recession and higher cyclical unemployment
• impact on the indebted
• hot money inflows (savings that chase the best interest rates internationally), savings from abroad flood into the country, exchange rate is strengthened, exports are more expensive, worsening current account deficit

Question 9

real life examples of contractionary monetary policy

Answer 9

Reduce demand-pull inflation

• 2004 bank of China: sell gov bonds thru open market operations, lowered money supply and increased interest rates

Central bank is apolitical, speed of implementation

• 2018, The Philippines experienced demand-pull inflation from strong C and I spending, central bank hiked interest rates five times (from 3% May, to 3.25% mid May, to 3.5% mid June, to 4% early Aug, to 4.5% late Sep, to 4.75% early Nov)

Business and Consumer Confidence

• Strong optimism in China (10% GDP growth in 2003), high interest rates ineffective

Unable to combat cost-push inflation

• will decrease output further, decreasing national income and sharper increase in unemployment

Alternative Policies

• supply-side policies for cost-push inflation, e.g. R&D, technological advancements, increasing productivity
• 2019 US, low rate of inflation despite unemployment rate at a 50 year low, old prices rising from USD45 to USD60

Question 10

real life examples of expansionary monetary policy 2008 Great Recession

Answer 10

2008 Great Recession

• real GDP consecutively declined from 2007 Q4 to 2009 Q2, total decline of 5.3%
• FED incrementally decreased interest rates (4.5% in end 2007, 2.0% in mid 2008, 0.25% in end 2008)
• increased money supply by buying gov bonds to lower interest rates

Central bank is apolitical, less time lag

• no parliamentary approval required
• began expansionary MP in Sept 2007, before the recession was officially announced
• decreased interest rates from 5.25% to 4.5%

Flexibility and precision

• US interest rates lowered 10 times across 2008
• from 4.5% to 0.25%
• allowed FED to fine-tune and correct economy without risking overstimulating the economy

Banks may be unwilling to lend/Consumers may be unwilling to increasing borrowing and spending

• borrowing volume decreased 79% from 2007 Q2 to 2008 Q4 despite lowered interest rates
• failed to prevent the recession that followed, with GDP continuing to contract in 2008 and 2009

Cannot deal with supply-side recession

• US 2008 recession partly due to rising oil prices, peaked at US$147 per barrel in July 2008
• increase COP of firms that depended on oil, SRAS decreased, recession

Alternative Policies

• consumer and firm confidence too low, should use expansionary FP to boost G
• China $586 billion stimulus plan in 2008 against great financial crisis, spending on public work projects like infrastructure, new airports and railroads
• G more direct in affecting AD

Supply-side causes of recession alternative policies

• use supply-side policies
• Great financial crisis: Singapore raised spending on R&D to more than $2 billion to mitigate the impacts of rising oil prices

Conclude

• pros: speed and precision, Central bank apolitical
• cons: limited to dependence on the willingness of households and firms to borrow, the willingness of financial institutions to lend
• more effective to prevent recession than fix one
• in practice, countries use a combination of expansionary FP and MP to combat recessions -> US set near 0% interest rate while conducting $153 billion stimulus package + 21% reduction in income tax and 55% reduction in corporate tax during 2008 recession