Monetary Policy

• Monetary policy


  The use of interest rates and the money supply to influence the level of aggregate demand and economic activity to achieve macroeconomic objectives
• Central bank


  The monetary authority responsible for regulating the country's financial system and implementing monetary policy
• Interest rate


  The price of money itself expressed as a percentage. Interest rates represent the cost of borrowing or lending money.
• Demand-side policy


  Any government strategy or plan to influence the level of aggregate demand (such as reducing interest rates to reduce costs of borrowing money and encourage expenditure)
• Money supply


  The amount of money in circulation within the economy at a given time, as determined by the central bank.
• By controlling the money supply, the central bank can control the level of economic activity.
• Inflation targeting


  The practice of central banks using monetary policy to influence the economy to achieve a specific rate of inflation
• Objectives of monetary policy

  1. Low and stable rate of inflation
  2. Low unemployment
  3. Reduce fluctuations in business cycle
  4. Promote economic stability and long-term growth
  5. External balance
• Lower interest rates decrease borrowing costs, encouraging consumption spending and investment expenditure. As a result, the AD curve shifts to the right and increases national output, reducing unemployment (ceteris paribus).
• Higher interest rates increase borrowing costs, discouraging consumption spending and investment expenditure. As a result, the AD curve shifts to the left and decreases the general price level (ceteris paribus). This can be used to control inflation levels.
• Monetary policies help stabilize fluctuations in the business cycle and achieve economic stability. A greater degree of certainty and confidence in consumers and firms encourages investments in physical and human capital for long-term economic growth.
• External balance


  The value of a country's export earnings being roughly equal to the value of its import expenditure
• If export earnings exceed import expenditure, there will be inflationary pressures in the long run as more money flows into the domestic economy.
• If import expenditure exceeds export earnings, there will be a decrease in aggregate demand as more money flows out of the domestic economy.
• Credit creation [HL]


  The process by which commercial banks create money from deposits from savers and use these funds as loans to borrowers.
• Wage-price spiral


  A circular cause of higher inflation due to trade unions negotiating higher wages owing to higher cost of living, which causes higher costs for firms
• Menu costs


  Because inflation impacts prices, firms are required to continually update their prices which is costly and inefficient. E.g. catalogues, price lists, menus.
• Deflationary spiral


  A circular cause of deflation in a weak economy; Lower consumption spending leads to less revenue for firms. As a result, firms hire less workers and invest less, leading to high unemployment and low consumer confidence. In turn, consumption spending falls further and the economy is stuck in a deflationary spiral.