Monetary policy

Chapter 23
Monetary policy
• Monetary policy refers to any policy measures or instruments to influence
the price or quantity of money. The three instruments of monetary policy
are the interest rate, the money supply and the exchange rate.
• Monetary policy seeks to influence aggregate demand . Again reflationary
or expansionary monetary policy is intended to increase aggregate
demand.
• In this case, this may be achieved by a cut in the interest rate, an increase in
money supply and a reduction in the foreign exchange rate.
• To reduce aggregate demand deflationary or Contractionary monetary
policy may be adopted.
• Monetary policy measures are usually implemented by the central bank of
the country.
The main tools of monetary policy are:
• Interest rates. changes in interest rates have been the main monetary
policy tool that central banks have used to control inflation and to
influence economic activity.
• Households and firms who want to borrow money have to pay
interest. Households and firms who lend money are paid interest.
• The interest rate charged by the central bank may be called the bank
base, repo or often just the interest rate. Changes in the interest rate
have been mainly used to achieve price stability.
• The money supply:
• A central bank may also target to increase or decrease money supply
in the economy. Changes in the quantity of money can influence
aggregate demand.
• To increase AD, a central bank can electronically print money and the
main cause of changes in the money supply is lending by commercial
banks.
• Exchange rate. Most economists also include the exchange rate as a
monetary policy tool. Central banks may manipulate the exchange
rate to raise or lower aggregate demand and so influence, for
example, price stability.
• Credit control: Central banks may also impose credit regulations on
commercial banks to help maintain financial stability and to influence
bank lending.
• Most central banks require the country’s commercial banks to hold a
proportion of their assets in a form that can be quickly sold and so
converted into cash.
• This is to ensure the commercial banks can meet their customers’
likely demand for cash even during a financial crisis
The difference between expansionary and
contractionary monetary policy
• Expansionary monetary policy may be used to increase aggregate
demand. A cut in the interest rate, an increase in the money supply
and a reduction in any restrictions on bank lending can be used to
achieve an increase in AD.
• To reduce aggregate demand AD, contractionary monetary policy
may be used. This might include a rise in the interest rate, a decrease
in the money supply and restrictions on bank lending.
The impact of expansionary and contractionary
monetary policy
• Monetary policy is mainly used to influence the price level
• In many countries, the main policy used to reduce demand-pull
inflation is monetary policy with the focus being on the interest rate.
• Many central banks are now given a target rate for inflation and
instructed to use interest rate changes to achieve it.
• If the inflation rate is rising outside its target range, a central bank is
likely to raise the rate of interest to reduce aggregate demand.
• The contractionary monetary policy measure may reduce
demand-pull inflation for a number of reasons.
• The cost of borrowing is likely to rise which may discourage
large-scale purchases including the purchase of houses and cars.
• Savings may be increased as the return from saving will rise. The
opportunity cost of saving is, of course, spending.
• Monetarists argue that the only way to reduce inflationary pressure is
to lower the growth of the money supply.
• If increases in the money supply do not exceed increase in output,
they suggest there will be no upward movement of the price level
• Commercial banks usually do keep their interest rates in line with the
interest rates of the central bank as it is the rate they will have to pay
if they need to borrow from the central bank.
• There is, however, no guarantee that they will always raise their
interest rates when the central bank increases its rate.
• Even if consumers are faced with higher interest rates, they may not
reduce their spending if they are optimistic about the future
• A rise in interest rates may have an adverse effect on investment.
This is because it will increase the cost of borrowing funds to invest
and will increase the opportunity cost of using profits to invest. The
resulting decrease in aggregate supply can push up the price level.
• Central banks may be worried that if they raise interest rates higher
than in other countries, they may attract an inflow of money into
their financial institutions from abroad. This may increase their
exchange rates.
• Countries that are members of an economic union may operate the
same interest rate and the same exchange rate as other members and
the area’s central bank may make the decisions on these areas of
monetary policy.
• A government will not seek to stop good deflation but it will try to
correct bad deflation because firms and households may be
pessimistic during periods of bad deflation and so may not spend
more even if there is more money in circulation and it becomes
cheaper to borrow.
• There are other reasons why monetary policy may not be very
effective in increasing aggregate demand when the inflation rate is
low or negative.
• For instance, a 2% interest rate is already low and, if firms and
households are not borrowing, it suggests they are concerned about
future economic prospects of the economy.
• In this situation, if the interest rate is reduced to 1.5%, it is unlikely to
increase borrowing and spending.
• Central banks may increase the money supply, increasing the funds
commercial banks have available to lend.
• The banks, however, may be reluctant to lend because they may think
there is an absence of creditworthy borrowers.
Monetary policy, equilibrium NI, the real
level of output and employment
If there is spare capacity in the
economy, an expansionary
monetary policy may result in
higher national income. A cut in
the rate of interest or an increase
in the money supply may
encourage more consumer
expenditure and investment.
The effect of contractionary monetary policy
There is a risk that
contractionary monetary
policy may reduce national
income, output and
employment.
However, if it is used when
the economy is operating
with all resources employed,
it may reduce the inflation
rate.
Effectiveness of monetary policy
• Commercial banks have a strong incentive to try to increase their
lending, so difficult for central bank to control money supply.
• There is a time lag between changing interest rates and the full effect
being transmitted to the macro economy.
• Interest rate changes may be a powerful policy measure but they are
also uncertain one.
• A rise in the rate of interest harms borrowers but benefits savers. A
higher interest rate may have an adverse effect on unemployment
and economic growth.