Section 2:

Macroeconomics
Section 2: Macroeconomics
2.1 The level of overall economic
activity
2.2 AD and AS
2.3 Macroeconomic objectives
2.4 Fiscal policy
2.5 Monetary policy
2.6 Supply-side policies
2.5 Monetary policy
ECB in Frankfort
Chinese Central Bank Governor Zhou Central bank governor Zhou Xiaochuan
chats with Canada's Finance Minister talks with France's Finance Minister
Flaherty during the G20 Finance Christine Lagarde at a G20 meeting in
Ministers and Central Bank Paris on Saturday. [Photo / AFP]
Governors Meeting in Busan
Expansionary monetary
policy, on the other hand,
expands or increases ...
 Unit Goals
Students should be able to define, diagram,
give examples of, and evaluate:
2.5.1 Interest rates
 Interest rate determination and the role of a
central bank
2.5.2 The role of monetary policy
 Monetary policy and short-term demand ma
nagement
 Monetary policy and inflation targeting
 Evaluation of monetary policy
2.5 Monetary policy

2.5.1 Interest rates

2.5.2 The role of monetary policy
Syllabus content
2.5.1 Interest rates
 Interest rate determination and the role of a central bank
 Describe the role of central banks as regulators of commercial banks and bankers to go
vernments.
 Explain that central banks are usually made responsible for interest rates and exchange
rates in order to achieve macroeconomic objectives.
 Explain, using a demand & supply of money diagram, how equilibrium interest rates ar
e determined, outlining the role of the central bank in influencing the supply of money.
2.5.2 The role of monetary policy
 Monetary policy and short-term demand management
 Explain how changes in interest rates can influence the level of aggregate demand in an
economy.
 Describe the mechanism through which easy (expansionary) monetary policy can help
an economy close a deflationary (recessionary) gap.
 Construct a diagram to show the potential effects of easy (expansionary) monetary poli
cy, outlining the importance of the shape of the AS curve.
 Describe the mechanism through which tight (contractionary) monetary policy can help
an economy close an inflationary gap.
 Construct a diagram to show the potential effects of tight (contractionary) monetary po
licy, outlining the importance of the shape of the AS curve.
 Monetary policy and inflation targeting
 Explain that central banks of certain countries, rather than focusing on the maintenanc
e of both full employment and a low rate of inflation, are guided in their monetary poli
cy by the objective to achieve an explicit or implicit inflation rate target.
 Evaluation of monetary policy
 Evaluate the effectiveness of monetary policy through consideration of factors includin
g the independence of the central bank, the ability to adjust interest rates incrementall
y, the ability to implement changes in interest rates relatively quickly, time lags, limited
effectiveness in increasing aggregate demand if the economy is in deep recession and c
onflict among government economic objectives.
 2.5 Monetary policy
2.5.1 Interest rates
 Interest rate determination and the rol
e of a central bank
 2.5 Monetary policy
Interest rate is the price of credit or borrowed money.
• the cost of borrowing money
• the return of saving money in banks
• the opportunity cost of spending money
A central bank is the monetary authority of a country o
r government’s bank. It is responsible for an economy’s
monetary policy and performs the functions of issuing c
urrency, managing the money supply and controlling in
terest rates.
• Central banks are regulators of commercial banks & b
ankers to governments.
• Central banks are usually made responsible for intere
st rates and exchange rates in order to achieve macro
economic objectives.
• the Fed, the ECB, the Bank of England, and Bank of Japan,
the People’s Bank of China and the Swiss National Bank.
IR determination: the money market
 Demand for money (DM)
DM = transaction D + speculative D
• Transaction demand:
- for buying goods & services
- relatively stable & autonomous to IRs changes
- positively influenced by real income & inflation
• Speculative demand:
- desire to hold money as an asset
- inversely related to IR: IR↑OC of holding cash↑ →savi
ngs↑→qty of money demanded↓
• DM curve: downward-sloping, negatively related to nominal IRs
 Money supply (SM)
SM = combined value of the currency and deposits of a country
• SM is independent of changes to nominal IRs
• determined by CBs with the goal of influencing nominal IRs
• SM curve: perfectly inelastic (vertical)
 IR determination: DM x SM
• Equilibrium IRs are determined by CB changing SM.
• SM↓ to SM1→IR↑ to IR1
• SM↑ to SM2→IR↓ to IR2

Diagram: Figure 18.2 The money market, PB P. 388

Role of central banks in influencing money supply
1. buying/selling (gov’t) bonds on open market
• expansionary: buying bonds from private banks
→ banks’ funds for making loans ↑
→ SM↑, IRs↓
• contractionary: selling bonds to private banks
→ banks’ funds for making loans ↓
→ SM↓, IRs↑
2. changing the reserve requirement (reserve ratio)
• reserve requirement is the percentage of deposits that ba
nks are required to have available at all times
• expansionary: lowering reserve requirement
→ bank loans ↑
→ SM↑, IRs↓
• contractionary: raising reserve requirement
→ bank loans ↓
→ SM↓, IRs↑
 2.5 Monetary policy
2.5.2 The role of monetary policy
 Monetary policy and short-term dema
nd management
 Monetary policy and inflation targeting
 Evaluation of monetary policy
2.4-2.6 Macroeconomic policies
1. Demand-side policies: AD (Keynesia
n)
 Fiscal policy
• Expansionary & contractionary
 Monetary policy
• Expansionary & contractionary
2. Supply-side policies: LRAS (New classica
l)
 Interventionist S-side policies
 Market-based S-side policies
 2.5 Monetary policy
 Monetary policy and short-term dema
nd management
 2.5 Monetary policy
Monetary policy is the set of central bank’s policies concern
ing money supply and interest rate. It may be used to mana
ge the level of aggregate demand (AD) and may be expansi
onary (to raise AD) or contractionary (to lower AD).
Expansionary (loose or easy) monetary policy is the policies
by the central bank to increase the money supply and redu
ce interest rates. This will increase consumption (C) and inv
estment (I), and thus increase AD.
Contractionary (tight) monetary policy is the policies by the
central bank to decrease the money supply and increase int
erest rates. This will reduce consumption (C) and investmen
t (I), and thus decrease AD.
Monetary policy: money supply & interest rates
• Expansionary → AD↑
• Contractionary (deflationary) → AD↓
*The money supply in an economy is an advanced topic that is not included
in the IB DP syllabus. We need only examine how changes in interest rates c
an affect the level of AD in an economy.
How changes in IRs can influence the level of AD in a
n economy:
 IRs as a tool of m.p. is the base rate (discount/prime rate)
• the rate charged by CBs for lending to commercial banks
• changes of base rate is a signal to banking system that bo
rrowing will become more/less expensive
 Inverse relationship b/t IRs and AD ( I & C)
• ↓IRs (base rate) → ↑C&I → ↑AD:
1. saving rate↓→↓saving return→↑C
2. durable goods loan rate↓ →↓bor
rowing cost →↑C (durable g)
3. mortgage rate↓ →↓
borrowing cost→↑C (houses)
4. business loan rate↓ →↓b
orrowing cost→↑I (diagram)
• ↑IRs (base rate) →↓C&I →↓AD:
saving return↑+ borrowing cost↑ (durable g & mtg + business loa
n)
1. Expansionary monetary policy: ↑SM, ↓IRs

Diagram: Figure 18.7

PB P. 393-4
• Mechanism through which exp.m.p. can help an econ
omy close a deflationary (recessionary) gap.
• Importance of the shape of AS curve: potential effects of e
xp.m.p. depend on the shape of the AS curve: can help wh
en the economy is producing below its FE output.
2. Contractionary monetary policy: ↓SM, ↑IRs
• Mechanism through which
con.m.p. can help an
economy close an
inflationary gap.

• Importance of shape of AS curve:

potential effects of con.m.p.
depend on the shape of the
AS curve: can help when
economy is producing beyond its
FE output, but gov’t is unlikely to
use c.m.p. when the economy is
already cooling down or in
recession.
Diagram: Figure 18.8 PB P. 394-5
 2.5 Monetary policy
 Monetary policy and inflation targeting
CBs of certain countries, rather than focusing on the ma
intenance of both full employment and a low rate of in
flation, are guided in their m.p. by the objective to achi
eve an explicit or implicit inflation rate target. (primary r
esponsibility: maintain a low & stable inflation rate)
• England, Canada, Australia, New Zealand, Poland (2.5%+/- 1%),
South Korea: CB sets an explicit target rate of inflation (official)
• The US: the Federal Reserve has an implicit target rate of infla
tion (informal)
Inflation targeting ↓inflationary expectations
→ trade unions won’t demand wage increases higher th
an the expected rate of inflation
→ L costs remain relatively stable
→ reduces cost-push inflationary pressure
 2.5 Monetary policy
 Evaluation of monetary policy
Strengths and weaknesses o
f monetary policy
PB P. 396-400
Strengths of monetary policy
1. Independence of the central bank (no political pressure)
• most CBs are independent of politics & not involved in election processes
(not affected by elections).
• this prevents politicians from asserting influence on m.p. to achieve their
political ends (for earning voters’ support).
• thus m.p. can be a very powerful & nimble tool. CBs can act on the facts o
f economy, even when such policies are politically unpopular.
2. Ability to adjust IRs incrementally
• Control: it is within the power of CB to adjust IR more discretely & finely tha
n legislators can do with f.p. (it can adjust as much/little as needed.)
• m.p. is thus more finely calibrated to solve e. problem at hand.
3. Ability to implement changes in IRs relatively quickly
• Speed: m.p. can be enacted by CB asa the problem is recognized, without
being delayed by legislators’ debates. (CBs skip process by which legislato
rs debate fiscal policy.)
• for a CB board, policy decisions are relatively immediate. This improves t
he chance of an exp. policy going into effect while the recession is still un
derway, or with a con.m.p. as inflation just begins to creep forwards.
4. No crowding out (↓IR)
• exp.f.p. often incurs gov’t borrowings, which will likely push up IRs & cro
wds out C&I.
• exp.m.p., on the other hand, involves lower IRs & does not cause any cro
wding out.
M.p. by CBs is both an art & a science: the timing & size of an IR chan
ge are crucial for the success of policy. In general, m.p. is considered r
ather flexible as CBs can change IR often & gradually, and can also rev
erse any decision.
Weaknesses of monetary policy
1. Time lags (effective in LR)
• while m.p. is quick to implement & destabilizing time lags may be shorter
than fiscal policy, it still takes time to go into effect.
• in times of high inflation, it takes several months of high IRs for investors
& consumers to change their behavior & reduce their spending.
2.Limited effectiveness in increasing AD if the economy is in
deep recession (low c/b confidence)
C&I depend on many other factors other than IR:
• no guarantee lower IRs will increase C& I: in times of deep recession, con
sumer & investor confidence is at its lowest point: consumers defer large
purchases & cut back spending; firms reduce output & I, thus confidence
crises make lowing IR meaningless. e.g. Japan’s ‘lost decades’ from 1991 t
o 2010.
• if IR is already very low (close to zero), it cannot be lowered any further a
s negative IR do not make any sense.
• if households & firms are burdened by heavy debts (indebtedness), no gu
arantee they will borrow & spend more.
3. Conflict among gov’t economic objectives
• as f.p., m.p. is unable to boost growth, reduce unempt & control inflation
at the same time. E.g. when con.m.p. is used to tame inflation, e. growth
will be reduced & unempt will rise, and the country’s X competitiveness
will also be weakened.
4. Inability to deal with S-side causes of instability
(cost-push inflation, natural unemployment)
• as f.p., it is powerless at stopping cost-push inflation.
5. Exp.m.p.: not work in ↑Y if e at/close to Yf due to S-side
constraints
Summary 1: Demand-side policies
 Fiscal policy: G & taxes
1. Expansionary fiscal policy: ↑AD
↑G, ↓T
2. Contractionary fiscal policy: ↓AD
↓G, ↑T
 Monetary policy: SM & IRs
1. Expansionary (loose, easy) monetary policy: ↑AD
↑SM, ↓IRs
2. Contractionary (tight) monetary policy: ↓AD
↓SM, ↑IRs
Summary 2: Evaluate monetary policy
Strengths:
1. Independence of the central bank
(no political pressure)
2. Ability to adjust IRs incrementally (control)
3. Ability to implement changes in IRs relatively qui
ckly (speed)
4. No crowding out (↓IR)
Weaknesses:
5. Time lags (effective in LR)
6. Limited effectiveness in increasing AD in deep rec
ession (↓IRs: low confidence)
7. Inability to deal with S-side causes of instability (c
ost-push inflation, natural U)
8. Conflict among gov’t e. objectives (una
ble to achieve growth, U & inflation goal at same time)
9. Exp.m.p.: not work in ↑Y if e at/close to Yf due to S-side
constraints
Expansionary monetary policy:↑AD→↑growth & ↓U
Strengths of ↓IRs: ↓IRs→C&I↑→AD↑→Y↑, (cyclical) U↓
1. Independence of central bank: no political pressure
2. Ability to adjust IRs incrementally: control
3. Ability to implement changes in IRs relatively quickly: speed
4. No crowding out: ↓IR
Weaknesses of ↓IRs:
5. not work in ↑Y if e at/close to Yf due to S-side constraints
6. Time lags: effective in LR
7. Limited effectiveness in increasing AD in deep recession:
• low c/b confidence: no guarantee for ↑C&I
• IRs cannot be lower below zero
3. Inability to deal with S-side causes of natural U
4. Conflict among gov’t e. objectives: D-pull inflation↑(↓XC/Bo
P)
Contractionary monetary policy:↓AD→↓inflation
Strengths of ↑IRs:↑IRs→C&I↓→AD↓→D-pull inflation↓
5. Independence of central bank: no political pressure
6. Ability to adjust IRs incrementally: control
7. Ability to implement changes in IRs relatively quickly: speed
Weaknesses of ↑IRs:
8. Time lags: effective in LR
9. Inability to deal with S-side causes of cost-push inflation
10.Conflict among gov’t e. objectives: growth↓ & cyclical U↑
 Fiscal policy Monetary policy
Strengths: Strengths:
1. Ability to target sectors of the 1. Independence of central bank
economy (no political pressure)
2. Direct impact on AD 2. Ability to adjust IRs
(con f.p.: D-pull inflation) incrementally (control)
3. Effective in promoting e. 3. Ability to implement changes
activity in a recession in IRs relatively quickly
(expf.p./↑G:growth;↓T:low (speed)
confidence) 4. No crowding out (↓IR)
4. Multiplier effects (HL)
Weaknesses: Weaknesses:
1. Time lags 1. Time lags (effective in LR)
(effective in very LR/legislative 2. Limited effectiveness in
procedure) increasing AD in deep recession
2. Political constraints (↓IRs: low confidence)
3. Crowding out (↑G:↑IR:↓C&I) 3. Inability to deal with S-side
diagram) causes of instability
4. Inability to deal with S-side (cost-push inflation, natural U)
causes of instability 4. Conflict among gov’t e. objectives
(cost-push inflation, natural U) (unable to achieve growth, U &
5. Conflict among gov’t e. objectives inflation goal at same time)
(unable to achieve 5. Exp.: not work in ↑Y if e at/close
growth, U & inflation goal at same to Yf due to S-side constraints
time)
6. Exp.: not work in ↑Y if e at/close
to Yf due to S-side constraints