<3.5: MONETARY POLICY> 

• MONETARY POLICY refers to policies laid down by the CENTRAL BANK which directly influences the MONEY SUPPLY which in turn influences the INTEREST RATES in an economy. 

• It is primarily used as a DEMAND-SIDE POLICY, aimed at influencing the level of AGGREGATE DEMAND in the economy VIA INVESTMENT AND HOUSEHOLD SPENDING.

• The easiest way to define a CENTRAL BANK is by understanding its specific roles:

  • BANKER TO THE GOVERNMENT:- The central bank acts as a banker to the government in ways that are similar to how commercial banks act as bankers to their customers. It HOLDS THE GOVERNMENTS MONEY (as deposits), it RECEIVES PAYMENTS FOR THE GOVERNMENT and MAKES PAYMENTS FOR THE GOVERNMENT (the government writes cheques (checks) paid from an account in the central bank). It also MANAGES GOVERNMENT BORROWING by SELLING BONDS to commercial banks and the public and acts as an ADVISOR TO THE GOVERNMENT on financial and banking matters.

  • BANKER TO COMMERCIAL BANKS:- The central bank also acts as a BANKER TO COMMERCIAL BANKS by holding deposits for them and can also MAKE LOANS TO THEM in times of need. (The central bank does not act as a banker to consumers and firms.)

  • REGULATOR OF COMMERCIAL BANKS:- The central bank REGULATES AND SUPERVISES COMMERCIAL BANKS, making sure they OPERATE WITH THE APPROPRIATE LEVELS OF CASH and according to rules that ensure the safety of the financial system. This is a very important function because the funds that commercial banks use to make loans are the savings and other deposits that consumers and firms deposit with commercial banks.

  • CONDUCT MONETARY POLICY:- The central bank is RESPONSIBLE FOR MONETARY POLICY, based on changes in the supply of money or the rate of interest. The central bank is also usually responsible for the DETERMINATION OF THE EXCHANGE RATE (the price of the domestic currency in terms of foreign currencies) because of the close relationship between interest rates and exchange rates.

• When you BORROW money, you need to COMPENSATE the lender for giving up their PRESENT CONSUMPTION, this compensation comes in the form of INTEREST and therefore can be referred to as BOTH the 'PRICE OF BORROWING MONEY' as well as the 'REWARD FOR SAVING/LENDING MONEY'.

• When the interest payment is expressed AS A PERCENTAGE OF THE AMOUNT BORROWED (Called the 'PRINCIPLE') it is called 'THE INTEREST RATE'.

• Its value is determined in the 'MONEY MARKET', where: 

THE SUPPLY OF MONEY = THE DEMAND FOR MONEY

"DOES MONEY MAKE THE WORLD GO ROUND?"

• Not in the scientific sense but it does make TRADE GO around. 

• Money is the MEDIUM OF EXCHANGE accepted between CONSUMERS and PRODUCERS when an EXCHANGE occurs hence it ENCOURAGES ECONOMIC ACTIVITY.

• We can infer that the more money that is available for spending the greater the likelihood of more EXCHANGE, which will in turn INCREASE AGGREGATE DEMAND.

• Money supply has various measures, but we are only concerned with the  MONEY SUPPLY that allows for day-to-day transactions, namely...

  • • • The cash In your pocket (Cash held by the public)

      • The balance in your deposit accounts (which are deducted from when you make a purchase using Paywave, Nets etc....)

      • (Note we are only concerned with the most liquid of assets as these are the ones that are used for day-to-day transactions)  

MONEY SUPPLY = CASH HELD BY PUBLIC + DEPOSITS

• From all our discussions so far about money supply are you under the impression (illusion) that... 

• MONEY SUPPLY = QUANTITY OF COINS & NOTES IN  DEPOSITS + CASH HELD OUTSIDE THE BANKS 

• If this was the case then we are assuming '100% RESERVE BANKING', in other words, banks must keep 100% of their customers' cash deposits and CAN NOT USE THEM TO MAKE LOANS, hence the money supply and conseqently interest ratewere limited to the quantity of notes and coins produced by the central banks.

• However, as we are now Long long ago banks had to keep 100% of reserves and were unable to loan it out, they simply acted as paid storage and movers of deposits (Custodians), as such the amount of money in the banking system + any money held outside of it equaled the money supply.

WITH 100% RESERVE BANKING:

MONEY SUPPLY = MONEY 

• However nowadays something has changed 

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• WHY DO BANKS ACCEPT DEPOSITS? As we know, banks do not just look after your money for the sake of it, they have a purpose for accepting your deposits, and that is to LOAN IT OUT and to EARN INTEREST and PROFITS.  

MORE LOANS = MORE PROFITS

• Banks can increase the number of LOANS (Also called 'CREDIT') because a portion of the initial deposit in a bank can be lent out multiple times FACILITATING MULTIPLE TRANSACTIONS, hence if the BANK'S ABILITY TO MAKE LOANS is INCREASED then there should, in theory, be more spending and vice versa.

MORE LOANS = MORE SPENDING

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• Long long ago banks had to keep 100% of reserves and were unable to loan it out, they simply acted as paid storage and movers of deposits (Custodians), as such the amount of money in the banking system + any money held outside of it equaled the money supply.

WITH 100% RESERVE BANKING:

MONEY SUPPLY = MONEY 

• However nowadays something has changed 

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• 
  

• WHY DO BANKS ACCEPT DEPOSITS? As we know, banks do not just look after your money for the sake of it, they have a purpose for accepting your deposits, and that is to LOAN IT OUT and to EARN INTEREST and PROFITS.  

MORE LOANS = MORE PROFITS

• Banks can increase the number of LOANS (Also called 'CREDIT') because a portion of the initial deposit in a bank can be lent out multiple times FACILITATING MULTIPLE TRANSACTIONS, hence if the BANK'S ABILITY TO MAKE LOANS is INCREASED then there should, in theory, be more spending and vice versa.

MORE LOANS = MORE SPENDING

But is the bank's ability to make loans limited to the amount of cash that is deposited? Nope! They can create money out of thin-air!

• Clearly from the example above we can see that THE HIGHER the RRR the SMALLER the BANKING MULTIPLIER and vice versa, therefore:

  • HIGHER RRR => SMALLER MULTIPLIER => FALL IN LOANS => FALL IN DEPOSIT CREATION => FALL IN MS => RISE IN INTEREST RATES => FALL IN 'C' & 'I' => CONTRACTION IN AD.

  • LOWER RRR => LARGER MULTIPLIER => RISE IN LOANS => RISE IN DEPOSIT CREATION => RISE IN MS => FALL IN INTEREST RATES => RISE IN 'C' & 'I' => EXPANSION IN AD.

• As mentioned above one of the roles of the central bank is to LEND TO COMMERCIAL BANKS on which it charges interest called the 'MINIMUM LENDING RATE' or the 'BASE RATE' in the UK. Often a commercial bank will run out of money to lend and will seek a loan from the CB. 

• HIGHER BASE RATE => HIGHER BORROWING COSTS FOR BANKS => LESS DEMAND FOR BORROWED FUNDS FROM CB => LESS RESERVES FOR BANKS TO LOAN => FALL IN LOANS => FALL IN DEPOSIT CREATION => FALL IN MS => RISE IN INTEREST RATES => FALL IN 'C' & 'I' => CONTRACTION IN AD.

• LOWER BASE RATE => LOWER BORROWING COSTS FOR BANKS => MORE DEMAND FOR BORROWED FUNDS FROM CB => MORE RESERVES FOR BANKS TO LOAN => RISE IN LOANS => RISE IN DEPOSIT CREATION => RISE IN MS => FALL IN INTEREST RATES => RISE IN 'C' & 'I' => EXTENSION IN AD.

• BONDS are financial instruments issued by BORROWERS. They are simply PROMISES to pay back the lender, all the money with INTEREST at a particular time in the future. Private investors, commercial banks, and the CB all hold bonds as part of their asset portfolios. In general, if the CB enters the 'Open market' and buys and sells bonds, like any other investor, then when the CENTRAL BANK

...BUYS a bond it GIVES MONEY to the SELLER, and that money will most likely find its way into the banking stystem which will kickstart the deposit creation process so MS↑, and when they...

...SELL a bond it TAKES MONEY from the BUYER, as such the withdrawal of these funds from the banking system (as the funds are likely to be in a bank as deposits in the first place) will reduce the depost creation process, so MS↓

...more accurately... 

BUYING BONDS => BIGGER MS:

• CB PRINTS MONEY AND BUYS BONDS ON THE OPEN MARKET => MORE NEW MONEY WILL BE DEPOSITED BY THE BOND SELLERS INTO THE BANKING SYSTEM => BANKS HAVE MORE RESERVES => MORE LOANS => MORE DEPOSIT CREATION => RISE IN MS => FALL IN INTEREST RATES => RISE IN 'C' & 'I' => EXPANSION IN AD.

SELLING BONDS => SMALLER MS:

• CB SELLS ITS GOV'T BONDS ON OPEN MARKET=> BUYERS OF THESE BONDS TAKE MONEY OUT OF BANKING SYSTEM => BANKS HAVE LESS RESERVES => LESS LOANS => LESS DEPOSIT CREATION => FALL IN MS => RISE IN INTEREST RATES => FALL IN 'C' & 'I' => CONTRACTION IN AD.

• 'QUANTITATIVE EASING' is very similar to open market operations only the government is not only buying and selling bonds but also transacting in other assets, which impact the MS in the same fashion. RWE.

Goto this LINK and download and complete the graphic organizer.

• INFLATION TARGETING involves the government setting a target inflation rate as their main economic objective, say of 2%. Focusing on a low and stable rate of inflation has both pros and cons.

• STABLE PRICES mean PREDICTABILITY when it comes to making SPENDING decisions that involve future income streams. Thus if firms and consumers can ANTICIPATE for the impact of INFLATION on the REAL VALUE of future returns much more accurately, they will be ENCOURAGED to engage in ECONOMIC ACTIVITY, thus MORE BORROWING AND LENDING TO FACILITATE INVESTMENT AND CONSUMER SPENDING as well as FDI.

• Inflation is part of interest rates, hence once they are low and stable BANKS will be MORE CONFIDENT ABOUT OFFERING LOANS AT LOWER PRICES, which again encourages economic activity.

• A stable economic environment will ATTRACT MNCs and FDI will rise, leading to ECONOMIC GROWTH.

• In order to commit to a target rate a government MUST

  • • In the event of STAGFLATION, in order to lower the price level the government must use a contractionary policy to return to the target price level which will result in a worsening recessionary gap and LEAD TO HIGHER UNEMPLOYMENT.

Monetary policy can be implemented more quickly than fiscal policy because it does not have to go through the political process, which is very cumbersome and time-consuming.

CENTRAL BANK INDEPENDENCE This is an advantage because independence from the government means the central bank can take decisions that are in the best longer term interests of the economy, and therefore exercises greater freedom in pursuing policies that may be politically unpopular (such as higher interest rates making borrowing more costly).

Even if a central bank is not independent of the government, monetary policy is still not subject to the same kinds of political pressures as fiscal policy, since it does not involve making changes in the government budget, whether in terms of government spending that would affect merit and public goods provision, or government revenues (taxes).

Monetary policy does not lead to crowding out, which may result from higher interest rates due to an expansionary fiscal policy (based on deficit financing). The monetary policy counterpart to an expansionary fiscal policy is an easy monetary policy, which leads to lower (not higher) interest rates.

Interest rates can be adjusted in very small steps, making monetary policy better suited to ‘fine tuning’ of the economy in comparison with fiscal policy. However, it should be stressed that it is also subject to limitations, and that there is in fact no policy tool that economists can use to fully ‘fine tune’ an economy.

Unlike fiscal policy, monetary policy can be implemented and changed according to perceived needs relatively quickly, because it does not depend on the political process. However, like fiscal policy, it remains subject to time lags (delays), including a lag until the problem is recognised, and a lag until the policy takes effect. Changes in interest rates can take several months to have an impact on aggregate demand, real output and the price level. By then, economic conditions may have changed so that the policy undertaken is no longer appropriate.

A major limitation of monetary policy is that the idea that investment and consumption spending will be encouraged through lower interest rates and greater borrowing, presupposes the following:

• Banks are willing to increase their lending to firms and consumers, and... 

• Firms and consumers are OPTIMISTIC enough to increase their borrowing 

However, in DEEP RECESSIONS...

• Banks may be unwilling to increase their lending, because they may fear that the borrowers might be unable to repay the loans. 

• Firms and consumers are PESSIMISTIC about future economic conditions, avoid taking out new loans, and may even reduce their investment and consumer spending,

HOW LOW CAN YOU GO? NEGATIVE INTEREST RATES

This is not something that happens often; however, it appears to have occurred during the Great Depression of the 1930s, in Japan in the late 1990s and early 2000s, and in the global recession that began in the autumn of 2008.

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. The pursuit of domestic objectives may conflict with the pursuit of objectives in the foreign sector.

Monetary policy is a demand-side policy, and is therefore unable to deal effectively with supply-side causes of instability, just like fiscal policy.

• Using Real-world example(s) evaluate the effectiveness of monetary policy compared to fiscal policy when an economy is in a deep recession. [15]

10-MARK-QUESTIONS:

• Explain how equilibrium interest rates are determined in an economy

• Explain how an increase in interest rates might affect the level of aggregate demand in an economy. 

• Explain how expansionary monetary policy can help to close a deflationary (recessionary) gap. 

15-MARK QUESTIONS:

• ‘The rate of inflation can be most effectively reduced through the use of monetary policy.’ To what extent do you agree with this statement? 

• Discuss the effectiveness of using expansionary monetary policy to reduce unemployment. 

• Discuss the view that the use of monetary policy is always the best way to reduce inflation.

• Discuss whether an increase in interest rates is the most effective way of reducing the rate of inflation in an economy.

• Evaluate the effectiveness of using monetary policy to reduce the rate of inflation.

• Evaluate the effectiveness of monetary policy when an economy is in deep recession. 

• Can you define monetary policy?  

• Can you list the main roles of a central bank? 

• Can you define interest rates?  

• Can you define money?  

• Can you explain how interest rates are determined?  

• Can you explain how banks can use credit creation to increase loans?  

• Can you explain how the central bank can control the money supply?  

• Can you explain the difference between real & nominal interest rates?  

• Can you define expansionary monetary policy?  

• Can you define contractionary monetary policy?. 

• Can you list the strengths of monetary policy? 

• Can you list the weaknesses of monetary policy?