Monetary Policy Flashcards
(24 cards)
What is a monetary policy?
The process by which monetary authority, like central bank, controls the supply of money, often targeting interest rates to ensure price stability
What is a central bank
A national bank that implements the monetary policy and prints currency
Role of central bank: banker to the government
- holds the government’s cash
- receives payments for government and makes them
- manages government’s borrowing by selling bonds to commercial banks and to the public, acts as an adviser to the government on financial and banking matters
Role of central bank: conduct monetary policy
The central bank is responsible for monetary policy, based
on changes in the supply of money or the rate of interest.
Role of central bank: banker to commercial banks
- holds deposits for them and can also make loans to them in times of need
- not a banker to consumers and firms
Role of central bank: regulator of commercial banks
- regulates and supervises commercial banks
- makes sure they operate with appropriate levels of cash and according to rules that ensure the safety of financial system
Goals of monetary policy
Low and stable rate of inflation
- low unemployment
- reduce business cycle fluctuations
- promote a stable economic environment for long term growth
- external balance of exports and imports
Explain central bank independence
Although the central bank is usually a government institution, it has a degree of independence from government interference in the pursuit of monetary policy
- independence ensures that monetary policy can be conducted in the best longer term interests of the economy, without interference from political pressures (elections)
What is inflation targeting and what centra bank uses
Monetary policy regime in which a central bank has a target inflation rate for the medium term and announces this inflation target to the public
- The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability.
● The central bank uses interest rates, its main short-term monetary instrument.
Name 5 advantages of inflation targeting
- Lower average rates of inflation
- More stable rates of inflation
- More accurate inflation expectations of firms and consumers
- Better coordination between monetary and fiscal policies
- More transparency and accountability of central banks
Name 5 disadvantages of inflation targeting
- Central bank has reduced abilities to control other objectives ( low unemployment)
- Central bank may have reduced the ability to respond to supply-side shocks
- Central bank may have reduced ability to respond to unexpected events (financial crises)
- Determining an appropriate inflation target
- Implementation difficulties (requires forecasting which can be unreliable)
Nominal rate of interest
- market rate that prevails at any moment in time. If your bank tells you that you will receive 5% interest on your savings, that is the nominal
interest rate.
Real rate of interest
Interest rate that has been corrected for inflation.
Nominal rate - inflation = real rate
Expansionary monetary policy
An increase in the money supply by the central bank is referred to as an expansionary policy since the objective is to expand aggregate demand and the level of economic activity
- therefore, lower interest rates will tend to increase consumer spending and investment
Contractionary monetary policy
A decrease in the money supply by the central bank is referred to as a contractionary policy, as the objective is to contract aggregate demand and therefore the economy
- therefore, higher interest rates will tend to decrease consumer spending and investment
Constraints on monetary policy: possible ineffectiveness in recession
- Interest rates cannot fall when approaching zero
As interest rates approach zero, they cannot fall further to encourage spending by firms and consumers - Low consumer and producer confidence
If firms and
consumers are pessimistic about future economic conditions,
they may avoid taking out new loans, and may even reduce
their investment and consumer spending, so that aggregate
demand will not increase. - Banks may be fearful of lending
In a severe recession,
banks may be unwilling to increase their lending, because
they may fear that borrowers might be unable to repay the
loans.
Constraints on monetary policy: conflict between government objectives
Manipulation of interest rates affects not only variables in
the domestic economy (consumption and investment
spending, inflation, unemployment) but also variables in
the foreign sector of the economy, such as exchange rates.
Constraints on monetary policy: may be inflationary
If it lasts too long it may be
inflationary, if aggregate demand increases beyond what is
necessary to eliminate a deflationary/ recessionary gap.
Constraints on monetary policy: Problematic when dealing with stagflation or
cost-push inflation.
Monetary policy is a demand-side
policy, and is therefore unable to deal effectively with
supply-side causes of instability.
Strengths of monetary policy: Interest rate changes can be incremental
Interest rates
can be adjusted in very small steps, making monetary policy
well suited to ‘fine tuning’ of the economy.
Strengths of monetary policy: ?
●Interest rates changes are reversible.
Strengths of monetary policy: short time lags
While monetary
policy can be implemented relatively quickly, it is subject to time lags as it takes time for interest rate changes to affect the economy, though these are not as long as in the case of fiscal policy.
Strengths of monetary policy: Central bank independence.
Independence from the government discussed above means the central bank can take decisions that are in the best longer-term interests of the economy, and can therefore pursue policies that may be politically unpopular (such as higher interest rates making borrowing more costly).
Strengths of monetary policy: no budget deficit or debt
It does not lead to budget deficits or increased levels of debt as fiscal policy does in the case of expansionary policy.
