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1/3 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 2/3 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…. 3/3 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.