Monetary and fiscal policy

• CENTRAL BANK

  -            holds the reserves of all the banks

  -            financial services to the government and to other banks

  -            takes care of currency stability and tries to ensure low inflation

  -            issues currency

  -            supervises a country’s monetary system
• What do Central banks do?

  -            setting interest rate ceilings and floors (these are maximum and minimum lending rates, that way they control the credit system and limit fluctations of the interest rate)

  -            issuing currency (printing money, controlling the amount of money in circulation)

  -            open market operations (buying and selling government bonds to and from commercial banks = alter amount of credit the banks can offer)

  -            supervising other banks (ensuring liquidity ratio so clients cann withdraw money when they want)
• What do Central banks do?

  -            controlling inflation (this way they are ensuring the price stability )

  -            supervising the exchange rate (by buying or selling large amounts of the national currency to prevent fluctations )

  -            providing currency (cash) to banks

  -            holding baks reserves (required reserve that are a guarantee to all the depositors that they can withdraw their money whenever they want )
• What do Central banks do?

  -            providing loans to banks (you've already learnt the word 'discount window' and these operations are called discounting = lending money to commercial banks)

  -            acting as lender of last resort (if a bank is on a verge of bankrupcy, they need to borrow money so they can give the money to investors, The cebtral bank is the one who will lend them that money. In other words, they aks as bankers' banks)

  -            acting as the government's bank
• Translate

  Interest rate – kamatna stopa

  Lending rate – kreditna stopa (diskontna stopa )

  Currency – valuta

  Money in circulation – novac u opticaju

  Open market operations – operacije na otvorenom tržištu

  Bonds - obveznice

  Price stability – stabilnost cijena

  Exchange rate – tečaj valute (devizni tečaj)

  Liquidity ratio – razina likvidnosti

  Bank reserves – bankovne rezerve (obvezne rezerve)

  Discounting - diskontiranje

  Lender of last resort – posljednje utočište

  Bankrupcy – bankrot
• Agregate demand


  The total level of demand for desired goods and services that makes up the GDP
• Full employment


  A situation in which all available labor resources are being used in the most economically efficient way. It is the highest amount of skilled and unskilled labor that could be employed within an economy at any given time.
• output(production)


  An amount produced or manufactured during a certain time
• Open market


  An economic system with no barriers to free market activity
• Reserve requierments


  Minimum amount of cash or cash-equivalents (a percentage of deposits) that banks and other depository institutions are required by law to keep on hand, and which may not be used for lending or investing.
• Discount rate


  The interest rate charged to commercial banks and other depository institutions for loans received from a central bank’s discount window
• bonds


  Securities representing the debt of the company or government issuing it
• Money supply


  The amount of liquid assets (usually cash) circulating in the economy.
• In a contractionary phase of the business cycle:

  Expansionary monetary policy

  -            Helps speed up the economy or increase economic growth

  -            Increasing money supply
• In an expansionary phase of the business cycle:

  Contractionary monetary policy

  -            Helps slow down economic growth

  -            Decreasing money supply
• The central bank influences an economy using monetary policy

  -            By deciding to increase or decrease money supply = monetary policy

  -            It increases liquidity to create economic growth. It reduces liquidity to prevent inflation.

  -            The central bank’s policy on controlling the money supply (by increasing or decreasing money supply depending on the economic conditions)

  -            Aim: to stabilize the economy at its full-employment potential
• 1. Reserve requirements

  -            Central bank holds reserves of other banks

  -            CB can demand from the banks to keep larger amounts of money as reserves in the CB (less is left to them to do business)

  -            CB can demand from the banks to keep smallers amounts of money as reserves in the CB (more is left to them to do business)

  -            The reserve ratio is the minimum amount of reserves that commercial banks must hold onto, rather than lend out or invest. This is a requirement determined by the country's central bank.
• 2. Discount rates

  -            An interest rate that a central bank charges other banks that take loans from it ( = borrow reserves from it)

  -            Banks will try to borrow from other banks (usually have lower interest rate than CB), but if it is not possible, they borrow from CB (lender of last resort)
• 3. Open market operations

  • Central bank sells bonds

  o   Commercial banks and brokers buy bonds from the central bank.

  o   The central bank gets money

  o   The central bank has to pay interest to the bondholder (central banks, brokers…) and repay the principal after e.g. 10 years

  o   Consequence?

  §  Less money left to commercial banks! (Contractionary monetary policy)

  • Central bank buys bonds

  o   Commercial banks and brokers sell bonds to the central bank

  o   Consequence?

  §  Commercial banks get a lot of cash! (Expansionary monetary policy)
• -            CB sells T-bonds to ‘soak up’ money from the system

  -            CB buys T-bonds to ‘inject’ money into the system
• In recession (an economy is contracting) - Expansionary monetary policy

  -            What can monetary policy do?

  o   Stimulate the economy by increasing the rate of output or aggregate demand

  -            How? Role of the central bank?

  o   To lower reserve requirements, drop the disount rate, buy more bonds = higher landing capacity of the banks

  -            What will banks do then?

  o   Make more loans, lower interest rates = easier to approve loans

  -            Result?

  o   Individuals and businesses will borrow and spend more
• Overheating economy (expansion) - Restrictive monetary policy

  • Excessive aggregate demand = too much pressure on the economy’s production capacities

  o   Aggregate demand has to be reduced

  o   Prices rise = inflation = redistribution of income, investments disrupted

  -            What can the monetary policy of the central bank do?

  o   Reduce the money supply: raise reserve requirements, increase discount rate, sell bonds

  o   = reduce lending capacity of the banks

  o   = higher interest rates, smaller loan availability, less investments, less government spending
• Fiscal policy

  -            A government policy on taxes and public spending.

  -            the government changes the levels and composition of taxation and government spending to influence the economy (Keynesian economics)

  -            What does it influence?

  o   Aggregate demand and the level of economic activity;

  o   Savings and investment in the economy;

  o   Income distribution.
• Keynesianism (governmental intervention)

  -            Government should intervene and counteract the business cycle

  -            During the boom: decrease their spending, increase taxation

  -            During the recession: increase their spending and decrease taxation, or Increase the money supply and reduce interest rates
• Friedman (monetarist argument) – the 1950s and 1960s

  -            Free markets and competition are efficient; government intervention has negative effects: increasing (or inflatinng) the money supply only changes price level (=leads to inflation) = no effect on output or employment

  -            Government :

  o   shouldn’t try to manage the level of demand

  o   should ensure constant and non-inflatory growth in the money supply

  o   Governments cannot predict a coming recession faster than companies = their fiscal measures have effect only when the economy starts recovering
• Keynesianism returns – beginning of the 21st century

  -            After the subprime crisis 2008

  -            Governments bailed out banks