<3.5: MONETARY POLICY>

--SYLLABUS CONTENT--

--DEFINITION--

"MONETARY POLICY refers to a DEMAND-SIDE policy implemented by the CENTRAL BANK to influence INTEREST RATES and the MONEY SUPPLY in order to achieve MACROECONOMIC OBJECTIVES, particularly PRICE STABILITY and influencing the level of AGGREGATE DEMAND."

↓

--WHAT IS THE INTEREST RATE?--

--TASK--

"Can you think of how INTEREST RATES can be described as both a PRICE and a REWARD?"

↓

"That's right; FROM THE PERSPECTIVE OF THE BORROWER, in exchange for having access to someone else's money, they must not only pay this 'principal' amount back in full but also pay an additional PRICE TO THE LENDER, which is equal to the INTEREST."

↓

"...and, FROM THE PERSPECTIVE OF THE LENDER, this extra payment can be seen as a REWARD for them giving up the opportunity to use that money themselves in the present."

↓

"When the INTEREST PAYMENT is expressed as a PERCENTAGE OF THE PRINCIPAL (the amount borrowed or saved), normally PER YEAR, it is known as the INTEREST RATE.

↓

--WHAT IS MONEY SUPPLY?--

“THE TOTAL STOCK OF MONEY AVAILABLE IN AN ECONOMY AT A PARTICULAR POINT IN TIME.”

"For our analysis of monetary policy, we are primarily concerned with highly liquid forms of money that can readily be used to make payments and carry out transactions, and hence impact AGGREGATE DEMAND."

These include:

CASH HELD BY THE PUBLIC

→ Notes and coins held by households and businesses.

BANK DEPOSITS

→ Money held in bank accounts that can readily be used to make payments using debit cards, electronic transfers and other payment methods.

Therefore, in our simplified model:

MONEY SUPPLY = CURRENCY HELD BY THE PUBLIC + BANK DEPOSITS

The CENTRAL BANK can use monetary policy to influence monetary conditions in the economy, including interest rates and the money supply.

--THE CENTRAL BANK--

--THE ROLE OF A CENTRAL BANK--

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.

--INTEREST RATE DETERMINATION HL--

"We already know that in a free market price is determined via the forces of supply and demand, and not surprisingly the 'price of borrowing' is also determined this way."

↓

--TASK--

"Look at the diagram below and explain why an increase in the money supply results in a fall in the interest rate."

"That's right, the increase has led to a surplus of mon

The CB will buy government bonds from banks at higher prices than they bought for, meaning the yields fall. All other government bond holders will raise their bond prices, lowering the yield more, other investors will buy commercial bonds lowering their rates, banks will also be keen to make loans but at a rate lower than before

--WHAT IS MONEY?--

"Does money make the world go round?"

Nope, but it does make TRADE GO round.

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 'EXCHANGES', which will in turn INCREASE AGGREGATE DEMAND."

--WHAT IS MONEY SUPPLY?--

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

--QUANTITY OF MONEY DEMANDED & THE ROI--

We are only concerned with the demand for money for the purpose of `TRANSACTIONS as this impacts spending and aggregate demand.
- - - Spending can come from TWO sources: It can be spending from your OWN SAVINGS or spending from BORROWED FUNDS. Either way, THE WILLINGNESS TO SPEND IS DIRECTLY RELATED TO THE RATE OF INTEREST.
    - For savers, the COST OF SPENDING MONEY is the INTEREST PAYMENTS THAT YOU FORGO from not leaving the money in the bank, while the COST OF BORROWING MONEY for consumers or investors is the INTEREST PAYMENTS THAT YOU MUST REPAY to the lender.
Hence WHEN INTEREST RATES ARE HIGH savers will keep their money in the bank, likewise, borrowers will be less likely to take on expensive loans, and therefore the QUANTITY DEMANDED OF MONEY IS LOW and vice versa, creating a downward-sloping demand for money curve.
Hence, we can say that THE QUANTITY DEMANDED OF MONEY IS INVERSELY RELATED TO THE INTEREST RATE.

--MONEY SUPPLY & THE ROI--

As mentioned earlier this refers to the sum of all cash held by the public + total deposits in checking accounts.

We will see that the SIZE OF THE MONEY SUPPLY is determined by the extent to which THE CENTRAL BANK allows COMMERCIAL BANKS (through a process called 'CREDIT CREATION') to increase deposits and is therefore completely UNRELATED TO THE RATE OF INTEREST. Hence, we can draw the Ms curve as a perfectly inelastic vertical line at a fixed quantity.

So how does the Government set the rates high or low? Well, they attempt to CONTROL THE MONEY SUPPLY. If they INCREASE THE SUPPLY OF MONEY and SHIFT the MONEY SUPPLY CURVE to the LEFT, they will RAISE the RATE and vice versa.

--INTEREST RATE DIAGRAM--

--CREDIT CREATION--

"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!"

--HOW THE CB CONTROLS MS (HL)--

--MINIMUM RESERVE-RATIO--

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.

--DISCOUNT/BASE-RATE--

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.

--OPEN MARKET OPERATIONS (OMOs)--

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 (QE)--

'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.

--🛑PORTFOLIO CHECKPOINT🛑--

--Use the mark scheme(s) below to construct the answer(s)--

--REAL VS NOMINAL RATES--

--NOMINAL RATE--

The NOMINAL RATE OF INTEREST refers to the market rate that is currently being offered by the banks.

--REAL RATE--

The REAL RATE OF INTEREST is the rate of interest adjusted for inflation.

'REAL RATE = NOM. RATE - INFLATION RATE'

(For example, if the inflation rate is 3% and the nominal rate is 5% then the real rate is 2%)

--TASK--

--Explain this answer using your excellent common sense--

--MONETARY POLICY--

EXPANSIONARY

EXPANSIONARY MONETARY POLICY is used when an economy is in a deflationary (recessionary) gap, with the aim of increasing overall spending and shifting the AD curve to the RIGHT. This is achieved by

increasing the money supply, which
lowers interest rates, which
encourages consumer spending (C) and business investment (I),
so aggregate demand (AD) increases.

CONTRACTIONARY

CONTRACTIONARY MONETARY POLICY is used when an economy is experiencing an inflationary gap, with the aim of reducing overall spending and shifting the AD curve to the LEFT. This is achieved by:

Decreasing the money supply, which
Raises interest rates, which
Discourages consumer spending (C) and business investment (I), so
Aggregate demand (AD) decreases.

--EVALUATION--

--STRENGTHS--

--RELATIVELY QUICK IMPLEMENTATION--

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.

--CB INDEPENENCE--

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).

--NO POLITICAL RESTRAINTS--

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).

--NO CROWDING OUT--

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.

--ABILITY TO 'FINE-TUNE'--

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.

--WEAKNESSES--

--STILL HAS TIME LAGS--

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.

--INEFFECTIVE IN RECESSION?--

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.

--CONFLICT WITH OTHER OBJECTIVES--

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.

--INABILITY TO DEAL WITH STAGFLATION--

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

--GOALS OF MONETARY POLICY--

--INFLATION TARGETING--

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.

--PROS: ENCOURAGES SPENDING--

"Our leaders use whatever means necessary to make sure that every year they meet their target of a 2% inflation rate; therefore, I will build this into my desired nominal rate without fear"
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.

--CONS: CONFLICTING OBJECTIVES--

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. See COVID.

--Use the mark scheme(s) below to construct the answer(s)--

--MONETARY BASE ≠ MONEY SUPPLY--

Hands up if you think that ALL the SGD COINS + NOTES (Called the 'Monetary base') is be EQUAL to the MONEY SUPPLY?
WRONG!!!!, look at this graphic, the actual currency in circulation (in your wallet for example) and the currency held in bank vaults is LESS THAN the MONEY SUPPLY. How come bank deposits are larger than the entire monetary base?

Page updated

Google Sites

Report abuse