Monetary policy

• Monetary policy

  The government uses interest rates and the supply of money to achieve macroeconomic objectives
• Tools used by the central bank for monetary policy

  • Base interest (discount) rates
  • Quantitative easing
  • Open market operations
  • Minimum reserve requirements
• Assumptions for credit creation

  • One bank represents the whole banking system
  • Firms and households only withdraw a certain proportion at any one time
  • Minimum reserve asset ratio requirement is set
  • Money withdrawn from the bank will be redeposited in the bank
  • Banks make a profit by charging a higher rate of interest to borrowers than they pay to depositors
• Credit creation process

  How credit creation works in an economy where a single bank represents the whole system
• The base interest rate influences interest rates set by banks and lending institutions
• The base rate is the interest rate charged by the central bank to the commercial banking sector
• If the central bank changes the base rate, commercial banks adjust their rates, affecting customers and the economy
• Market interest rates are influenced by demand and supply of money
• There is a negative relationship between the rate of interest and the demand for money
• As interest rates decrease, the quantity demand for money increases
• The supply of money in the economy is set by the central bank and the banking system
• The supply of money is fixed in a given time period and is perfectly inelastic
• The equilibrium interest rate is set where the demand for money equals the supply of money
• The market interest rate changes with changes in the demand for money or the supply of money
• The market interest rate will change if there is either a change in the demand for money or the supply of money
• If there is a fall in aggregate demand in a recession, there will be fewer transactions and the money demand curve will fall from Md to Md1 causing a fall in the market of interest
• The real interest rate makes an allowance for inflation and is calculated as: Nominal interest rate – inflation rate = real interest rate
• The real interest rate is used by firms and households to give them information about the returns they pay or receive on money borrowed or saved
• If an individual saves money at a nominal interest rate of 4 per cent and inflation is 5 per cent, they know the real value of their savings will be falling
• The government has a number of monetary tools it can use to achieve its policy objectives
• The minimum reserve requirement is the quantity of cash banks must hold as a reserve or keep in deposit at the central bank
• If the central bank wants to reduce the money supply, it can increase the minimum reserve requirement of commercial banks
• If the minimum reserves requirement is reduced by the central bank, the banking system can create more credit and there is an increase in the money supply
• Open market operations are a monetary tool used by central banks to regulate the money supply by buying and selling government bonds
• If the government sells government bonds in the financial markets, the money supply falls
• If the central bank buys government bonds in the financial markets, the money supply increases
• Quantitative easing involves central banks using open market operations to increase the money supply by purchasing large quantities of government and corporate bonds
• The banking system uses the additional cash from quantitative easing to create credit and the money supply increases which reduces interest rates
• Expansionary monetary policy is where the government reduces interest rates and increases the supply of money to increase consumption and investment to increase aggregate demand
• Expansionary monetary policy is normally used to increase economic growth and reduce unemployment
• When the central bank reduces its base rate, it charges a lower interest rate to commercial banks and they pass on this reduction in interest rates to households and firms in the form of lower interest loans (personal loans, mortgages and credit car
• How the policy works

  Central bank reduces its base rate, charges a lower interest rate to commercial banks, who pass on the reduction in interest rates to households and firms in the form of lower interest loans (personal loans, mortgages, and credit cards). Lower interest rates mean less interest is paid on the money firms and households hold in banks, causing consumption and investment spending to rise, increasing aggregate demand. The increase in aggregate demand leads to a rise in GDP as firms produce more, leading to an increase in employment
• Monetary transmission mechanism

  • Rise in aggregate demand and subsequent rise in demand for labour reduces unemployment. Expansionary monetary policy closes the deflationary gap. Interest rates are reduced
• Expansionary monetary policy is relatively quick to apply, giving flexibility in its application. Central banks can respond immediately to a rise in unemployment or a fall in economic growth by decreasing base interest rates
• Monetary policy can be applied incrementally, adjusting to changes in economic growth and unemployment rates. Interest rates can be continuously adjusted to tackle changes in those rates
• Independent central banks have some freedom from government political influence, preventing the use of expansionary monetary policy to create economic boom conditions before an election
• Rise in aggregate demand may lead to an increase in the average price level and inflation, especially if it leads to an inflationary gap
• When interest rates are very low, the central bank may have little room to reduce rates further in response to rising unemployment or falling economic growth
• Commercial banks may not pass on interest rate reductions, increasing their profits. They can pay lower interest costs to the central bank but maintain the same interest rate for borrowers
• Decrease in interest rates relies on households and firms changing consumption and investment in response. Low confidence in a recession may hinder this response, particularly for large investment projects and expensive purchases