Download IB Economics Section 2.5 Monetary policy

IB ECONOMICS
SECTION 2.5 MONETARY POLICY
13. Describe the role of central banks as regulators of
commercial banks and bankers to governments.
A central bank, reserve bank, or monetary authority is a
public institution that manages a state's currency, money
supply, and interest rates.
Central banks also usually oversee the commercial banking
system of their respective countries.
In contrast to a commercial bank, a central bank possesses a
monopoly on increasing the nation's monetary base, and
usually also prints the national currency, which usually serves
as the nation's legal tender.
Examples include the European Central Bank (ECB), the
Federal Reserve of the United States, and the People's
Bank of China.
13. Describe the role of central banks as regulators of
commercial banks and bankers to governments.
The primary function of a central bank is to manage the
nation's money supply (monetary policy), through active
duties such as managing interest rates, setting the reserve
requirement, and acting as a lender of last resort to the
banking sector during times of bank insolvency or financial
crisis.
Central banks usually also have supervisory powers,
intended to prevent bank runs and to reduce the risk that
commercial banks and other financial institutions engage in
reckless or fraudulent behavior.
Central banks in most developed nations are institutionally
designed to be independent from political interference.
14. Explain that central banks are usually made responsible for interest
rates and exchange rates in order to achieve macroeconomic objectives.
Functions of a central bank may include:







implementing monetary policies.
determining Interest rates
controlling the nation's entire money supply
the Government's banker and the bankers' bank ("lender of
last resort")
managing the country's foreign exchange and gold reserves
and the Government's stock register
regulating and supervising the banking industry
setting the official interest rate – used to manage both inflation
and the country's exchange rate – and ensuring that this rate
takes effect via a variety of policy mechanisms
15. Explain, using a demand and supply of money diagram, how equilibrium
interest rates are determined, outlining the role of the central bank in influencing
the supply of money.
At the equilibrium interest rate, the quantity of money demanded equals
the quantity of money supplied.
At any other interest rate, this condition does not hold and, in the money
market, it will force the interest rate to the equilibrium level.
For example, if the interest rate is temporarily above the equilibrium level,
there will be an excess supply of money.
Recall that at high interest rates, people are more likely to hold financial
assets in interest-bearing securities.
When the interest rate is above the equilibrium level, there will be more
money available than people wish to hold.
Interest rates must fall to encourage people to hold more money and
fewer bonds.
One way to look at this is an excess supply of money means there is that
an excess demand for bonds.
This causes the price of bonds to rise, which drives down the interest rate.
15. Explain, using a demand and supply of money diagram, how equilibrium
interest rates are determined, outlining the role of the central bank in influencing
the supply of money.
Supply and Demand in the Money
Market
Money holdings vary inversely with the
interest rate. The question that arises
next is, what determines the interest
rate?
The supply of money, coupled with
money demand, determines the
interest rate.
Recall that the Fed influences the
supply of money in the economy by
conducting open market operations
and by making changes in the discount
rate or the reserve requirement.
At any point in time, the supply of
money is fixed, thus the money supply
curve is a vertical line.
15. Explain, using a demand and supply of money diagram, how equilibrium interest
rates are determined, outlining the role of the central bank in influencing the supply of
money.
If the interest rate is below
the equilibrium rate, there
will be an excess demand
for money.
Because people want to hold
more money than there is
available, people will try to
sell bonds in order to
increase their money
holdings.
This drives down bond prices
and causes interest rates to
rise.
15. Explain, using a demand and supply of money diagram, how equilibrium
interest rates are determined, outlining the role of the central bank in
influencing the supply of money.
Showing the effect of a
reduction in interest rates
If we assume the economy has an
recessionary gap, then a
reduction in interest rates by the
Central Bank will increase
aggregate demand because
saving is discouraged, new
borrowing and spending is
encouraged, and confidence
and investment will increase.
The effect of the increase in
aggregate demand on real
output and the price level
depends upon the elasticity of
aggregate supply.
15. Explain, using a demand and supply of money diagram, how equilibrium
interest rates are determined, outlining the role of the central bank in
influencing the supply of money.
The Loanable Funds Market
The graph depicts the market for loanable
funds. The blue curve represents the demand for
loanable funds, or the amount of funds that firms
and individuals wish to borrow at each interest
rate.
The demand curve slopes downward because at a
lower interest rate, firms and individuals can
borrow money more cheaply.
The lower cost of loans encourages a higher
quantity of borrowing.
The red curve represents the supply of loanable
funds, or the amount that individuals wish to save.
The supply curve slopes upward because at a
higher interest rate, individuals get a higher return
on their money and are willing to save more.
The point at which the supply and demand curves
intersect is called the market equilibrium, and is
marked E1 in the graph.
Understanding Interest Rates: Nominal, Real And Effective
Nominal Interest Rate
The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the
stated interest rate of a given bond or loan. The nominal interest rate is in essence the actual
monetary price that borrowers pay to lenders to use their money. If the nominal rate on a loan
is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them.
Real Interest Rate
The real interest rate is slightly more complex than the nominal rate but still fairly simple. The
nominal interest rate doesn’t tell the whole story, because inflation reduces the lender's or
investor’s purchasing power so that they cannot buy the same amount of goods or services at
payoff or maturity with a given amount of money as they can now.
The real interest rate is so named because it states the “real” rate that the lender or investor
receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate.
If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%,
then the real rate of interest is only 2%. The real rate of interest could be said to be the actual
mathematical rate at which investors and lenders are increasing their purchasing power with their
bonds and loans.
It is actually possible for real interest rates to be negative if the inflation rate exceeds the
nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real
interest rate of -1% if the inflation rate is 4%. A comparison of real and nominal interest rates
can therefore be summed up in this equation:

Nominal interest rate – Inflation = Real interest rate
16. Explain how changes in interest rates can influence the level
of aggregate demand in an economy.
Changes in the supply of
money can cause the
equilibrium interest rate to
change.
If the central bank increases the
money supply, the supply curve
of money will shift to the right.
This will cause the equilibrium
interest rate to fall.
Conversely, a decrease in the
money supply will cause the
equilibrium interest rate to rise.
16. Explain how changes in interest rates can influence the level
of aggregate demand in an economy.
The effects of a change in
money demand on the
equilibrium interest rate.
Recall that changes in
aggregate output (Y) or the
price level can shift the demand
for money.
With an increase in aggregate
output, the demand for money
will increase.
This causes the demand curve
for money to shift to the right
and increases the equilibrium
interest rate.
16. Explain how changes in interest rates can influence the level
of aggregate demand in an economy.
MONEY SUPPLY, AGGREGATE DEMAND DETERMINANT:
Money Supply is one of several specific aggregate demand
determinants assumed constant when the aggregate demand
curve is constructed, and that shifts the aggregate demand
curve when it changes.
An increase in the money supply causes an increase
(rightward shift) of the aggregate demand curve.
A decrease in the money supply causes a decrease
(leftward shift) of the aggregate demand curve.
Other notable aggregate demand determinants include
interest rates, inflationary expectations, and the federal
deficit.
16. Explain how changes in interest rates can influence the level
of aggregate demand in an economy.
A key function of the central bank is controlling the total amount of
money circulating about the economy.
Money is what the public uses to buy real production and to undertake the
four aggregate expenditures--consumption expenditures, investment
expenditures, government purchases, and net exports.

With more money, aggregate expenditures are greater.

With less money, aggregate expenditures are lower.
As such, changes in the money supply induces changes in aggregate
demand.
An increase in the money supply increases aggregate demand and a
decrease in the money supply decreases aggregate demand.
(Opportunity cost of household and business spending is measured by
interest rates.)
16. Explain how changes in interest rates can influence the level
of aggregate demand in an economy.
16. Explain how changes in interest rates can influence the level
of aggregate demand in an economy.
16. Explain how changes in interest rates can influence
the level of aggregate demand in an economy.
17(A). The Federal Reserve System has three tools that, in
principle, can be used to control the money supply and interest
rates.
Open Market Operations:
The central bank buys and sells U.S. Treasury securities.
Such buying and selling affects the amount of excess reserves
that banks have available to make loans and to create money.
This is the primary monetary policy tool used by the central
bank.
If the central bank buys Treasury securities, banks have more
reserves which they use to make more loans at lower interest
rates and increase the money supply.
If the central bank sells Treasury securities, banks have fewer
reserves which they use to make fewer loans at higher interest
rates and decrease the money supply.
17 (A). The Federal Reserve System has three tools that, in principle,
can be used to control the money supply and interest rates.
Discount Rate:
The central bank can also adjust the interest rate that it charges
banks for borrowing reserves.
Higher or lower rates affect the amount of excess reserves that
banks have available to make loans and create money.
If the central bank lowers the discount rate, then banks can
borrow more reserves, which they can use to make more loans at
lower interest rates, which then increases the money supply.
If the central bank raises the discount rate, then banks can
borrow fewer reserves, which they use to make fewer loans at
higher interest rates, which then decreases the money supply.
Changes in the discount rate are most often used as a signal for
monetary policy actions.
17 (A). The Federal Reserve System has three tools that, in principle,
can be used to control the money supply and interest rates.
Reserve Requirements:
The central bank can further adjust the proportion of reserves that
banks must keep to back outstanding deposits (the reserve ratio).
Higher and lower rates affect the deposit multiplier and the
amount of deposits banks can create with a given amount of
reserves.
If the Fed lowers reserve requirements, then banks can use
existing reserves to make more loans and thus increase the money
supply.
If the Fed raises reserve requirements, then banks can use existing
reserves to fewer more loans and thus decrease the money
supply.
This tool is seldom used as a means of controlling the money supply.
17 (A). The Federal Reserve System has three tools that, in principle,
can be used to control the money supply and interest rates.
The money multiplier is the amount of money that banks
generate with each dollar of reserves.
Reserves is the amount of deposits that the Federal Reserve
requires banks to hold and not lend.
Banking reserves is the ratio of reserves to the total amount
of deposits.
The money multiplier is the ratio of deposits to reserves in
the banking system.
Money Multiplier Formula
The money multiplier is the reciprocal of the reserve ratio:
 Money multiplier = 1/R, where R is the reserve ratio
17. Describe the mechanism through which easy (expansionary)
monetary policy can help an economy close a deflationary
(recessionary) gap.
Expansionary monetary policy is monetary policy that seeks to
increase the size of the money supply.
Neoclassical and Keynesian economics significantly differ on the
effects and effectiveness of monetary policy on influencing the
real economy; there is no clear consensus on how monetary policy
affects real economic variables (aggregate output or income,
employment).
Both economic schools accept that monetary policy affects
monetary variables (price levels, interest rates).
Monetary policy relies on a number of tools: monetary base,
reserve requirements, discount window lending and interest rates.
18. Construct a diagram to show the potential effects of easy (expansionary)
monetary policy, outlining the importance of the shape of the aggregate
supply curve.
19. Describe the mechanism through which tight
(contractionary) monetary policy can help an economy close
an inflationary gap.
Contractionary monetary policy is monetary policy
that seeks to reduce the size of the money supply.
This directly reduces the total amount of money
circulating in the economy.
A central bank can use open market operations to
reduce the monetary base.
The central bank would typically sell bonds in exchange
for hard currency.
When the central bank collects this hard currency
payment, it removes that amount of currency from the
economy, thus contracting the monetary base.
19. Describe the mechanism through which tight (contractionary)
monetary policy can help an economy close an inflationary gap.
Contractionary policy can be implemented by
requiring banks to hold a higher proportion of their
total assets in reserve.
By requiring a higher proportion of total assets to be
held as liquid cash, a central bank or finance ministry
reduces the availability of loanable funds.
This acts as a reduction in the money flow.
The contraction of the monetary supply can be
achieved indirectly by increasing the nominal interest
rates.
20. Construct a diagram to show the potential effects of tight
(contractionary) monetary policy, outlining the importance of the shape of
the aggregate supply curve.
21. Explain that central banks of certain countries, rather than focusing on the maintenance
of both full employment and a low rate of inflation, are guided in their monetary policy
by the objective to achieve an explicit or implicit inflation rate target.
Inflation targeting is an economic policy in which a central bank estimates
and makes public a projected, or "target", inflation rate and then attempts to
steer actual inflation towards the target through the use of interest rate
changes and other monetary tools.
Because interest rates and the inflation rate tend to be inversely related, the
likely moves of the central bank to raise or lower interest rates become more
transparent under the policy of inflation targeting. Examples:


if inflation appears to be above the target, the bank is likely to raise interest
rates. This usually (but not always) has the effect over time of cooling the
economy and bringing down inflation.
if inflation appears to be below the target, the bank is likely to lower interest
rates. This usually (again, not always) has the effect over time of accelerating
the economy and raising inflation.
Under the policy, investors know what the central bank considers the target
inflation rate to be and therefore may more easily factor in likely interest
rate changes in their investment choices. This is viewed by inflation targeters
as leading to increased economic stability.
21. Explain that central banks of certain countries, rather than focusing on the maintenance of
both full employment and a low rate of inflation, are guided in their monetary policy by the
objective to achieve an explicit or implicit inflation rate target.
The different types of policy are also called monetary
regimes.
The distinction between the various types of monetary
policy lies primarily with the set of instruments and target
variables that are used by the monetary authority to
achieve their goals.
21. Explain that central banks of certain countries, rather than focusing on the maintenance of
both full employment and a low rate of inflation, are guided in their monetary policy by the
objective to achieve an explicit or implicit inflation rate target.
Monetary Policy:
Target Market Variable:
Long Term Objective:
Inflation Targeting
Interest rate on overnight debt
A given rate of change in the
CPI
Price Level Targeting
Interest rate on overnight debt
A specific CPI number
Monetary Aggregates
The growth in money supply
A given rate of change in the
CPI
Fixed Exchange Rate
The spot price of the currency
The spot price of the currency
Gold Standard
The spot price of gold
Low inflation as measured by the
gold price
Mixed Policy
Usually interest rates
Usually unemployment + CPI
change
22. Evaluate the effectiveness of monetary policy through consideration of factors including the independence of
the central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates
relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep
recession and conflict among government economic objectives.
Independence of the central bank:
During the 1990s central banks saw increased independence in terms of the
mandate to achieve set goals such as growth, inflation and unemployment.
The distortionary effects of governments using monetary policy for its own
gains were increasingly viewed by academics and policy-makers alike as
outweighing the advantages of using fiscal and monetary policies in a
concerted effort to implement set policy goals.
One key advantage put forward by the monetarist/new-classical school is
that the crowding out effect is avoided.
Another is that one can avoid a ‘political business cycle’ where different
governments issue widely different policy objectives over time.
Finally, it seems empirically reasonably clear that increased central bank
independence results in a lower long run level of inflation.
22. Evaluate the effectiveness of monetary policy through consideration of factors including the independence of the
central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates
relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep
recession and conflict among government economic objectives.
The ability to adjust interest rates incrementally:
The ability to adjust interest rates incrementally means that
policy makers to monitor the effectiveness of monetary policy.
It is common for interest rates to change in increments of
0.25%, thus reducing the risk of causing huge disruptions to the
economy.
The ability to implement changes in interest rates relatively
quickly:
This means that monetary policy can be used to influence and
fine-tune macroeconomic objectives.
Central banks review the state of the economy and adjust
interest rates accordingly, often on a monthly basis.
22. Evaluate the effectiveness of monetary policy through consideration of factors including the independence of the
central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates
relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep
recession and conflict among government economic objectives.
Time lags: (lags in monetary policy)
Businesses and consumers do not normally change their spending
plans immediately upon an interest rate change.
Businesses must reevaluate, make new decisions and order
reductions or expansions in production and expenditures. This
means that months pass before spending is affected.
Monetary policy typically has a short policy lag (the time it
takes to create and implement policy) and a long expenditure
lag (the time it takes businesses and consumers to adjust to the
new interest rates).
The total lag time is usually 9-12 months and varies a good
bit. Thus when the Federal Reserve changes interest rates now,
their decisions will affect economic conditions in approximately a
year from the time of the change.
22. Evaluate the effectiveness of monetary policy through consideration of factors including the independence of the
central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates
relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep
recession and conflict among government economic objectives.
Limited effectiveness in increasing aggregate demand if the
economy is in deep recession:
During deep recessions central banks will commonly have
lowered interest rates to fight possible deflation and fuel
consumption/investment.
The problem is that when money supply has increased to the
point where interest rates hit zero, there is nowhere left to
go.
When confidence levels are low, firms will not borrow money to
invest even at low rates of interest, if the demand for products
remain low.
Bank may be reluctant to lend when they feel that the
borrowers will be unable to repay.
22. Evaluate the effectiveness of monetary policy through consideration of factors including the independence of the
central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates
relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep
recession and conflict among government economic objectives.
Conflict among government economic objectives:
 The effectiveness of monetary policies aimed at reducing
aggregate demand is limited too, as ‘hot money’ (the flow
of money into the country to gain from higher rates of
interest) will increase the exchange rate. This makes exports
more expensive and so worsens the trade balance.
 Conflict among government economic objectives exist, so a
cut in interest rates or an increase in the money supply (to
influence the level of economic activity, for example) can
conflict with other macroeconomic objectives, such as
inflation (price stability)
22. Evaluate the effectiveness of monetary policy through consideration of factors including the independence of
the central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates
relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep
recession and conflict among government economic objectives.
Conflict among government economic objectives:
 The use of tight monetary policy can be counterproductive as it
restricts economic activity and discourages foreign direct
investment in the country – for example, higher interest rates raise
the cost of production, which negatively impact on profits, jobs
and economic growth.
 Monetary policy influences aggregate demand rather than
having a direct impact on the economy’s long-run aggregate
supply.
 In the short-run, monetary policy is generally more effective in
dealing with demand-pull inflation than in getting an economy
out of an economic depression, which might require the use of
fiscal and supply-side policies.
22. Evaluate the effectiveness of monetary policy through consideration of factors including the independence of the
central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates
relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep
recession and conflict among government economic objectives.
Evaluation of monetary policy:
The advantages:
 Evidence shows that, in normal conditions, interest rates have a
direct and powerful effect on household spending, which
suggests that consumers are highly interest rate elastic.
 The central bank is independent from government and can
make decisions free from political interference.
 Interest rates can be adjusted on a monthly basis, which
contrasts with discretionary fiscal policy which cannot be
adjusted at such regular intervals.
 While the full effects of interest changes may not be
experienced for up to a year, there is often an immediate
effect on confidence. The time-lag on output is estimated to be
around one year, and on the price level, around two years.
22. Evaluate the effectiveness of monetary policy through consideration of factors including the independence of the
central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates
relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep
recession and conflict among government economic objectives.
The disadvantages:
 There are still time lags to see the full effects, and there are some
negative effects.
 Raising interest rates can negatively affect on investment
spending and the housing market, and the exchange rate and
hence the balance of payments.
 There is also the problem of the dual economy - are high rates
set for the booming service sector, or low rates for the depressed
manufacturing and export sector?
 The money supply is difficult to control in practice, so
controlling interest rates is preferable.
 Interest rates may fall to very low levels during a deep recession,
and while the demand for credit may rise, the supply may
become trapped in the system, known as the liquidity trap.
liquidity trap
This is a situation where any
increase in the supply of money
has no effect on interest rates –
the short term interest rate is
zero.
This negates any expansionary
monetary policy where an
increase in the supply of money
(Sm0 to Sm1) has no effect on
interest rates. Since interest
rates remain unchanged there
is no decrease in savings or
increase in
consumption/investment.
22. Evaluate the effectiveness of monetary policy through consideration of factors including the independence of the
central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates
relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep recession
and conflict among government economic objectives.
fiscal and monetary policy – comparison
Effectiveness of Monetary Policy and Fiscal Policy
Key considerations for judging the effectiveness of monetary policy
include the ability of central bankers to forecast future economic
conditions and the time it takes for policy actions to take effect.
Some estimates suggest that changes in interest rates initiated by
central banks can take up to 18 months to be felt across the whole
economy.
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