3.2 Monetary policy

DEFINITIONS:

1. Monetary Policy: Involves central banks altering the supply of money, exchange rates, and interest rates to influence macroeconomic performance.
2. Symmetric Inflation Targeting: An inflation target where the central bank takes action when inflation rises above the target and takes action when inflation falls below the target.
3. Asymmetric Inflation Targeting: An inflation target where the central bank takes action when inflation rises above the target only (e.g. European Central Bank).
4. Liquidity Trap: Occurs when economic agents have a preference for holding cash or very liquid assets, meaning a cut in base interest rates will have little to no effect on aggregate demand (AD).
5. Quantitative Easing: When the central bank electronically prints money and uses it to buy government bonds and corporate bonds to increase the money supply in the economy and lower interest rates.
6. Money Supply: Money in circulation in the economy.

Explanation with the aid of a diagram

3.2.1 Changes in Interest Rates

Interest rates are the cost of borrowing money and the return for saving money. They play a crucial role in the economy, influencing consumer spending, business investment, inflation, and economic growth. Central banks, such as the Bank of England, adjust interest rates to manage economic stability.

Effects of Changes in Interest Rates:

Diagram:

AD1 to AD2 (Shift Right): This shift represents a decrease in interest rates. Lower interest rates reduce the cost of borrowing, increasing consumer spending and business investment, thus shifting AD to the right.

AD1 to AD2 (Shift Left): This shift represents an increase in interest rates. Higher interest rates increase the cost of borrowing, reducing consumer spending and business investment, thus shifting AD to the left.

3.2.2 Changes in Money Supply

Explanation:

The money supply in an economy refers to the total amount of money available in the economy at a particular point in time. Changes in the money supply can have significant effects on various economic variables, such as interest rates, inflation, and economic growth. Central banks, such as the Federal Reserve in the United States or the Bank of England in the UK, control the money supply through monetary policy tools like open market operations, the discount rate, and reserve requirements.

Key Effects of Changes in Money Supply:

Diagram:

To illustrate the effect of changes in the money supply, consider the Money Market diagram with the money supply and money demand curves.

By understanding these dynamics, economists and policymakers can predict and manage the effects of changes in the money supply on the broader economy.

3.2.3 Inflation Rate Targets

3.2.4 Quantitative Easing (QE)

Quantitative Easing (QE) is a monetary policy tool used by central banks to stimulate the economy when conventional monetary policy has become ineffective. QE involves the central bank purchasing long-term securities, such as government bonds and mortgage-backed securities, to increase the money supply and lower interest rates.

Objectives of QE:

1. Increase Money Supply: By buying securities, the central bank injects money directly into the economy, increasing the money supply.
2. Lower Interest Rates: QE aims to lower long-term interest rates, making borrowing cheaper for businesses and consumers.
3. Stimulate Economic Activity: Lower interest rates encourage spending and investment, which can boost economic growth and employment.

Mechanism of QE:

1. Asset Purchases: The central bank creates money electronically and uses it to buy long-term securities from financial institutions.
2. Increased Bank Reserves: The purchase of these securities increases the reserves of the banks, enabling them to lend more.
3. Lower Yields on Securities: The increased demand for these securities raises their prices and lowers their yields (interest rates).
4. Spill over Effects: Lower yields on government bonds lead investors to seek higher returns in other assets, such as corporate bonds and stocks, which can reduce borrowing costs for businesses and increase wealth effects.

Diagram:

Below is a simplified diagram illustrating the effects of QE:

Summary:

Quantitative Easing (QE) involves central banks purchasing long-term securities to increase the money supply and lower interest rates. This policy aims to stimulate economic activity by making borrowing cheaper and encouraging spending and investment. The diagram illustrates how QE shifts the money supply curve, increasing the quantity of money and reducing interest rates.

3.2.5 Influence of Exchange Rates

Exchange rates represent the value of one currency in terms of another currency. They play a crucial role in international trade and investment, affecting the prices of goods, services, and assets between countries.

Key Concepts:

1. Appreciation: When the value of a currency rises relative to another currency.
2. Depreciation: When the value of a currency falls relative to another currency.

Influence on the Economy:

Diagram:

The diagram below illustrates the effect of currency appreciation and depreciation on the aggregate demand (AD) curve.

---

AD1 to AD2: Appreciation shifts the AD curve to the left (AD1 to AD2), leading to a lower price level and a decrease in real GDP.

Currency Appreciation:

Currency Depreciation:

AD1 to AD2: Depreciation shifts the AD curve to the right (AD1 to AD2), leading to a higher price level and an increase in real GDP.

---