Unit 5.3 - Monetary policy

• Monetary policy


  Any policy tools that affects the price level or quantity of money
• Monetary policy


  • A demand-side policy
  • Applied by the central bank
  • Utilises interest rates, money supply, credit regulations and exchange rates
• Tools of monetary policy

  • Credit regulations
  • Money supply
  • Interest rates
  • Exchange rates
• Credit regulations


  Rules affecting bank lending
• Money supply


  The total amount of money in a country
• Interest rates


  The price of borrowing and the reward for saving [base/bank/repo rate]
• Exchange rates


  The value of one currency for the purpose of conversion to another
• Expansionary monetary policy


  • Decrease interest rate
  • Increase in money supply
  • Reduction in restrictions on bank lending
• Contractionary monetary policy


  • Rise in interest rate
  • Decrease in money supply
  • Restrictions on bank lending
• Central banks are given a target rate for inflation and instructed to use interest rates to achieve this
• If inflation is increasing

  Raise the rate of interest to reduce AD [contractionary policy]
• Raising interest rates


  • Cost of borrowing will rise, discouraging large-scale purchases
  • Savings may be increased (return)
• Raising interest rates may not always decrease spending as commercial banks may not raise interest rates and consumer confidence may still be high
• Monetarists argue that to reduce inflationary pressure, the growth of money supply needs to be lowered
• Raising interest rates


  Could increase the cost of borrowing, leading to depreciation of capital stock, decrease in AS, and push up the price level
• If there is spare capacity in the economy


  Expansionary monetary policy could lead to higher national income
• Expansionary monetary policy


  • Encourage consumer expenditure and investment
  • Higher AD could increase real output
  • Higher output could lead to increased employment
• Contractionary monetary policy


  Could decrease national income, output and employment
• If used when the economy if at full employment, contractionary monetary policy may reduce inflation
• Monetary policy is difficult to control as commercial banks are profit driven
• There is a time lag of around 18 months between changing interest rates and the full effect being transmitted into the macroeconomy
• There is high uncertainty regarding changes to the interest rate as it affects everyone differently