Download Chapter 38 – fiscal policy - The Good, the Bad and the Economist

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Chapter 39 – monetary policy
Objectives of the chapter
•
Define interest rates, supply of money and
monetary policies.
•
Explain how interest rates and/or the supply of
money can be used to influence the economy.
•
Explain how central bank rates (e.g. discount
rate) sets commercial bank rates.
•
Evaluate and discuss possible outcomes of
expansionary/contractionary monetary policies in iv.
terms of trade-offs and other scenarios.
i.
Define: interest rate, central bank rate
(discount rate), supply of money, monetary
policy
ii.
Describe/outline: links between Sm and r;
iii.
Explain/distinguish/draw how a change
in r affects AD…and thus U, infl and ∆Y;
how CB rates influence commercial bank
rates; AD shifts due to monetary policies
Evaluate/discuss:

Limits to monetary policy.

Trade-offs

NPOS: the issue of fixed exchange rates
and inflation targeting
Key terms: interest rate (price of money), money supply, base rate, current
balance (Xrev – Mexp basically), tight and loose monetary policy
Monetary policy – using r and/or Sm to adjust AD (again, link to *”Big 4”*)
a. Interest rate – note that there is a borrowing rate and a
deposit rate (banks live off the differential)
b. Supply of money – very basically it is the amount of
money circulating in the economy (notes and coins
plus bank deposits in accounts)
Notes on syllabus:
2) Interest rate
a. Effect on S
i. …fill in yourself…
1. rise in r → ↑S (RoR is greater…opp cost of C is
greater)
b. Effect on C and I
i. …fill in yourself…
1. rise in r → ↓C…↓I (opp cost of C has risen…and
the cost of borrowing is higher)
c. Effect on I and C
i. …fill in yourself…
1. fall in r → ↑I … ↑C (cost of I has fallen…)
d. Effect on Dhome currency and thus the exchange rate
i. …fill in yourself…
1. rise in r (domestic)…→ ↑D dom curr…and thus an
appreciation of the dom curr
3) Monetary policies and demand-side
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a. Aim: by way of using monetary policy CB can influence AD and
thus the key macro variables of Y, i, U and external balance.
i. Also: even-out the fluctuations of the business cycle! (*”Cut
the peaks…to fill-in the troughs…”*)
b. Monetary policies – changing r (or Sm)
i. Any change in r will have an effect on the willingness of
consumers to buy goods and of firms to invest
1. ↓r → ↓S and ↑C and ↑I → ↑AD
2. ↑r → ↑S and ↓C and ↓I → ↓AD
3. if the CB ↑Sm this will force r down…figure out
the rest (↑Sm → ↓r → ↑C and I → ↑AD…so
↑Y, ↑infl, ↓U)
4. if the CB ↓Sm this will force up r…go figure
(opposite!)
c. Trade-offs (in the *”Big 4”*)
i. ∆Y and i (↓r…leads to growth but poss infl)
ii. i and U (↓r…creates jobs…but poss infl)
iii. ∆Y and environment (↓r…↑Y and ↓U…but poss neg
exts rise)
iv. ∆Y and income distr (…rising incomes are NOT spread
“equally” – see China!)
v. ∆Y and effects on exchange rate (…rising r to dampen the
economy (called “tight” monetary policy)…will attract
deposits from abroad…and thus lead to an appreciation of
the domestic curr)
From chapter 41: relationships between objectives

Result of fiscal/mon policies
o Expansionary policies: ↓U, ↑growth, increased tax rev
(exp…output and income)
 Possible neg effects: inflation…if tariffs are used (e.g.
govt lowers import taxes) → ↑M…, alt if Y rises then M
rise too, poss deficits and debt due to increased G and/or
lower T,
o Contractionary: reduced inflation, increased int’l competitiveness,
poss increase in govt rev, poss improvement in current account (as
Y falls…and thus M fall)
 I missed! Dampen “swings” in business cycle by increased
T and lower G during “boom”…and then using the fiscal
surplus to stimulate AD during “downturn/recession”.
o
Tight and loose monetary policy (NOTE: I “lose my wallet” but
keep “loose change in my pocket”!)
 Expansionary/loose (r↓…or ↑Sm → ↑AD and ↑Y):
↑Y…. ↓U…etc…
 Poss neg effects: inflation….depreciation of H.C….
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

Contractionary/tight (opposite from above!): lower
inflation, poss stronger currency (as DHC rises) ,
dampening of overheating economy, savers are rewarded,
lower inflation can benefit curr acc by making home
goods relatively cheaper and stimulating X (and a fall in
M)
Neg effects; lower growth…less inv and C…disincentivised savers….poss increase in U…
 Also: poss in LR that this is detrimental to curr
acc?!
Revision questions
1. How did CBs across the world act during the “financial meltdown” in
2008?
2. Why might a small trade nation – Sweden or Switzerland – be highly
reluctant to use strong expansionary monetary policies to stimulate AD?
3. Evaluate the possible outcomes – trade-offs – when CBs implement
monetary policies aimed at lowering unemployment.
4. Right now, many of the world’s largest economies are uncertain whether
they can implement “loose” monetary policies. Explain what this means
and why they are uncertain.
5. Tricky one and definitely NPOS! Explain why a country cannot have a
specific inflation target and at the same time a fixed exchange rate.