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Monetary Policy
Week 9 (final lecture of
MT)
Professor Dermot McAleese
OUTLINE
 What is monetary policy?
 How does it affect economy?
 Effectiveness of Monetary policy
 Issues in Monetary policy
MONETARY POLICY
 Primary target
 Intermediate targets
 Instruments
Primary target
PRICE STABILITY
Intermediate targets
 Money supply
 Interest rates
 Exchange rate
Instruments
Direct:
 Interest regulations
 Credit controls
Market based:
 Discount rate
 Reserve ratio
 Open market
operations
INTEREST RATE
The interest rate is the amount of interest
paid per unit of time as a fraction of the
balance outstanding.
Fisher relation
REAL interest rate = NOMINAL
interest rate minus inflation
r=i-
WHAT DETERMINES INTEREST RATES?
r
S
D1
D
r1
r
D1
D
A
A1
I, S
S
r
S1
E
S
E1
D
S1
I, S
INTEREST RATES AND ECONOMIC
ACTIVITY
 Substitution effect
 Income effect
 Wealth effect
 Investment effect
MONETARY POLICY AND AGGREGATE
DEMAND
Substitution effect
(-) r

(-) S

(+) C
Cash flow (income) effect

(-) r

Wealth effect
(-) r

(-) r


(-) r
(+) cash flow of borrowers
(-) cash flow of lenders
(+) in asset values
(+) C
(+) I
MONETARY POLICY AND AGGREGATE
DEMAND (Cont.)
CB credibility effect
(-) r

(+) domestic confidence in CB
(-) r

(-) domestic price and wage
increases
Exchange rate effect
(-) r

depreciation of real
exchange rate  (+) X, (-) M
Expansionary monetary policy
Higher money base
Lower interest rate
Growing private sector credit
Asset price
inflation
More spending
More output
in short run
Consumer price increase
Inflation
Capacity
constraint/
tight labour
market
MONETARY POLICY CAN SOMETIMES FAIL
• Problem 1: Keynes’ liquidity trap where nominal interest
rates fall to such a low level that no further cuts are
expected (LM curve flat)
• Problem 2: IS curve very steep, so outward shift of LM
affects interest rate but not output
• Problem 3: If prices are falling, the real interest interest
rate rises, investment is deterred. Since nominal interest
rates cannot fall below zero, central bank powerless. The
Japan case.
ISSUES in MONETARY POLICY
 Active vs. passive
 Rules vs. discretion
 CB as a supervisor
 Transparency vs. secrecy
Conclusions:
1. Conservative view: “How much do we really
know about monetary policy?
Enough to prevent it doing harm, but not
enough to use it to do good.”
David Laidler, Taking Money Seriously, 1996
2. Monetary policy an art not a science. Secret
lies in responding in timely way (compare Japan
and US)
3. So far counter-cyclical policies have
prevented major and prolonged depression. Will
this continue?