2.5. Monetary Policy

Explain, using a demand and supply of money diagram, how equilibrium interest rates are determined, outlining the role of the central bank in influencing the supply of money.

Monetary policy is the use of interest rates and money supply changes to manage the overall level of demand in the economy and, therefore, help achieve the economic objectives set out in previous sections. For examinations you will need to show how monetary policy is used to achieve macroeconomic objectives. So, think about how monetary policy is used to:

• Control inflation

• Help produce growth

• Keep employment as high as possible

• Maintain a satisfactory balance of payments

Keynes’ Theory of Liquidity Preference

• Keynes developed the theory of liquidity preference in order to explain what factors determine the economy’s interest rate.

• According to the theory, the interest rate adjusts to balance the supply and demand for money.

Money Supply

It’s the name economists give to all the money circulating in a given nation’s economy. The US money supply comprises currency (the dollar bills and coins issued by the Treasury and the Federal Reserve System of federal and state banks) and various kinds of deposits held by the public at banks and similar institutions. However, there are several different definitions of the money supply, known as M1, M2 and M3. The broadest measure is M3.

These measures correspond to three definitions of money that the Federal Reserve uses:

• M1, a narrow measure of money’s function as a medium of exchange[1]; It comprises all the paper cash and coins in circulation, plus the total amount in current accounts and instant access savings accounts.

• M2, a broader measure that also reflects money’s function as a store of value[2]; It is made up of M1 plus various other types of savings account, money market accounts[3] and certificate of deposit accounts worth less than $100,000.

• M3, a still broader measure that covers items that many regard as close substitutes for money; M2, plus other items that many regard as close substitutes for money – certificates of deposit worth more than $100,000, deposits of Eurodollars[4] and repurchase agreements[5].

[1] A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services

[2] A store of value is an item that people can use to transfer purchasing power from the present to the future.

[3] The money market is a financial market in which only short-term debt instruments (usually 12 months maturity or less) are traded i.e. 3, 6 and 12-month Government bonds.

[4] US Dollars deposited in foreign banks outside the United States or in foreign branches of US banks are called EuroDollars.

[5] Repurchase agreements (repos) are effectively short-term loans (usually with a maturity of less than two weeks) in which government bonds serve as collateral, an asset that the lender (usually a large corporation) receives if the borrower (commercial banks) does not pay back the loan

How does the money supply affect the economy?

When the supply of money grows, consumers feel wealthier and are encouraged to spend more on goods and services. Businesses respond to rising sales by buying more raw materials and increasing production – in turn requiring more labour and more capital. However, if the money supply expands too much, prices will start to rise, especially if the growth in output is hitting the limits of capacity. As inflation accelerates, lenders demand higher interest rates on money they lend out to compensate them for the fact that, when they get their money back, it won’t be worth as much as it was when they first lent it out. Conversely, when the supply of money falls, or when its rate of growth falls, the economy can be affected in opposite ways. Economic activity declines and the result is lower inflation (disinflation).

The money supply is controlled by the central bank through:

• Open-market operations i.e. buying and selling of government bonds

• Changing the reserve requirements i.e. the amount of funds deposit-taking institutions must hold as reserves – not allowed to lend out and housed in the institution’s vault.

• Changing the discount rate i.e. rate that the central bank charges commercial banks for funds borrowed. The central bank also sets the base rate that commercial banks lend to each other.

Because it is fixed by the Fed the quantity of money supplied does not depend on the interest rate. The fixed money supply is represented by a vertical supply curve.

Money Demand

Money demand is determined by several factors.

• According to the theory of liquidity preference, one of the most important factors is the interest rate.

• People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.

• The opportunity cost of holding money is the interest that could be earned on interest-earning assets.

• An increase in the interest rate raises the opportunity cost of holding money.

• As a result, the quantity of money demanded is reduced.

Equilibrium in the Money Market

According to the theory of liquidity preference:

· The interest rate adjusts to balance the supply and demand for money.

· There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied.

Explain how changes in interest rates can influence the level of aggregate demand in an economy.

Monetary policy is conducted by the central bank of the country. Monetary policy refers to the attempts to manipulate either the market rate of interest or the money supply so as to bring about desired changes in the economy.

1. Open-Market Operations[1] Welker Wikinomics

Open Market Operations: The first tool of monetary policy requires a central bank to increase or decrease the supply of liquid money in the economy by buying or selling non-liquid assets from from within the banking system. “Open-market operations” refers to the buying and selling of government bonds by a nation’s central bank to increase or decrease the supply of money.

v To increase the money supply, the Fed buys government bonds from the public.

v To decrease the money supply, the Fed sells government bonds to the public.

There is an inverse relationship between the price of government bonds and their yields (the interest rates on government bonds).

· Therefore, when a central bank intervenes in the market for government bonds by buying bonds, this decreases their supply and raises the price, decreasing the yields on government bonds. This is knowns as a expansionary monetary policy.

· If the central bank sells government bonds on the open market, their supply increases, decreasing their prices and increasing their yields. This is known as a contractionary monetary policy.

The effect of a central bank’s intervention in the bond market can be seen in the diagrams below:

Monetary policy and short term demand management

Explain how changes in interest rates can influence the level of aggregate demand in an economy. Remember AD is made up of C+I+G+X-M.

Describe the mechanism through which easy (expansionary) monetary policy can help an economy close a deflationary (recessionary) gap.

Expansionary monetary policy

Governments may choose to use expansionary (loose or easy) monetary policy in times of recession or a general downturn in economic activity. This was in widespread use by many governments following the financial crisis on 2008.

In this situation, governments use monetary policy to stimulate the economy. They may do this by lowering interest rates or by increasing the money supply. Following the 2008 credit crunch, periods of Quantitative Easing (Q.E.) took place where governments increased the money supply by purchasing assets of longer maturity than only short-term government bonds with the objective of lowering longer-term interest rates.

Lowering interest rates encourage firms (I) and individuals (C) to borrow and spend more. Increasing the money supply into the national income will similarly increase spending. Either way, the level of demand in the economy (Shifting AD to the right) should rise and help encourage economic growth.

Reflationary monetary policies include:

• Lowering interest rates

• Increasing money supply

These policies should boost aggregate demand and, therefore, the equilibrium level of income.

The increase in aggregate demand occurs for several reasons, including:

1. Falling savings

2. More new borrowing

3. Lower costs of servicing existing debts

4. Rising confidence

5. Greater export demand

6. Rising asset values

7. Rising business investment

For Keynesians, any increase in AD on the horizontal section of the AS curve will not be inflationary. Prices will only increase when full employment is reached and the AS curve becomes vertical. Contrast this with the neoclassical view using a vertical LRAS where in the long run expanding AD does not increase Real Output or lower unemployment.

However, this policy may cause demand-pull inflation. We can see from Figure 4, that the new equilibrium would involve a higher price level. Keynesians argue that reflationary monetary policy sometimes referred to as a loosening or easing of monetary policy, is appropriate where there is spare capacity, as they believe that the economy can settle at any equilibrium level of output.

Monetary policy and inflation targeting

Explain that central banks of certain countries, rather than focusing on the maintenance of both full employment and a low rate of inflation, are guided in their monetary policy by the objective to achieve an explicit or implicit inflation rate target.

Most countries choose to aim for a target range for the inflation rate and use monetary policy only when that range is likely to be exceeded. In USA the Fed nowadays is also concerned with low unemployment so quantitative easing is used when unemployment becomes an issue. In Brazil the target Inflation Rate is 2.5% to 6.5%.

Example of Asian countries using inflation targeting

Relationship between monetary policy instruments and the inflation target

• How successful have the Fed and ECB been in attaining their implicit inflation targets?

• Canada: a successful inflation targeting story?

• Is inflation targeting (explicit) by some central banks more success than non-inflation targeting central banks?

• See http://www.frbsf.org/education/publications/doctor-econ/2007/march/inflation-targeting-monetary-policy-costs-benefits/
• Limitation of inflation targeting from an institutional perspective

Evaluate the effectiveness of monetary policy through consideration of factors including the independence of the central bank, the ability to adjust interest rates incrementally, the ability to implement changes in interest rates relatively quickly, time lags, limited effectiveness in increasing aggregate demand if the economy is in deep recession and conflict among government economic objectives.

The advantages of interest rate policy

Powerful and direct

Evidence shows that interest rates have a direct and powerful effect on household spending, the evidence suggesting that UK consumers are interest rate elastic.

Independent

The Bank of England’s Monetary Policy Committee is independent of government and can make decisions free from political interference.

Easy to implement

Interest rates can be changed on a monthly basis, which contrasts with changes in discretionary fiscal policy, which cannot be made at such regular intervals.

Quick effect on confidence

While the full effects of interest changes may not be experienced for up to two years, there is often an immediate effect on confidence. The time lag affecting output is estimated to be around one year, and on the price level, around two years.

The disadvantages of interest rate policy

There are still time lags to see the full effects, and there are some other negative effects, including:

Investment can suffer

Investment spending is inversely related to interest rates, and higher rates increase the opportunity cost of investment. Long term, economic growth will suffer if high interest rates persist.

The housing market can suffer

The housing market is very sensitive to changes in interest rates, so individual changes tend to be small, partly so as not to have an excessive effect on housing.

The dual economy

There is also the problem of the dual economy. Should rates be set high to control the inflating service sector, or low rates for the depressed manufacturing and export sector? Unlike previous recessions, in the current recession all sectors of the economy have been suffering in a similar way, so rates have been set at historically low levels without any fear of inflation.

The liquidity trap

Reducing interest rates in a recession may be ineffective because of the so-called liquidity trap. This theory is associated with Keynes, and his analysis of the Great Depression. In a recession interest rates will fall towards zero, as in the UK during 2009, following the financial crisis. In this case, banks and other financial intermediaries prefer to hold cash rather than make loans. Therefore, while borrowing may be stimulated, liquidity is not released through the system - it is 'trapped' and unavailable.