Edward F5C 31 IAL Unit 2 – Ch 40 Macroeconomic demand-side policies

Instruments of policy
 The variables that the government is attempting to control
Demand-side policies
 Monetary policy – manipulation by governmnet of monetary variables
 Fiscal policy – use of taxes, government spending and government borrowing to
achieve its objectives
Reflationary policies Deflationary policies
 Increases aggregate demand  Reduces aggregate demand
 e.g. expansionary fiscal policy and  e.g. contractionary fiscal policy and
expansionary monetary policy contractionary monetary policy
Monetary policy
Interest rates as  Wealth effect – Decrease in interest rate --> increase in
a monetary demand for assets --> Rise in price of bonds and assets
instrument owned by individuals who receive interest on the money
they loaned --> increase in financial wealth --> positive
impact on Consumption and Investment
Quantitative  Refers to where the central bank buys financial assets in
easing as a exchange for money in order to increase borrowing and
monetary lending in the economy
instrument  Base rate – the interest rate the the central bank charges
if a bank borrows money from it overnight
 With QE , central bank buys bonds from banks in
exchange for money --> Commercial banks own more
money -- > able to lend out to customers -- > encourage
borrowing for consumption and investment
 Lowering interest rate --> fall in exchange rate --> more
competitive exports and less competitive imports -->
increase in current account
 Evaluation of borrowing : if the duration of loan is long ,
such as 5 years, interest rate may increase due to
economic activities fluatuations
Changes in  Risky lending : Lending to borrowers that won’t be able
lending criteria to repay the debts (50%+ cannot afford repayments)
 Central bank therefore plays a greater role in supervising
banks --> make sure that commercial banks lend
responsibly to customers
Reserve asset  Commercial bank keep enough liquid assets to repay
requirement their customers
 Liquidity : money or goods that can be sold immediately
to pay debts
Capital  Banks must hold sufficient capital to absorb bad debts
requirement loss without becoming insolvent
The role of  Aim : implement monetary polict to achieve price stability
central banks in  Inflation targeting :publishes a target inflation rate and
the conduct of attempts to steer actual inflation using monetary tools
monetary policy  As banker to the government : Central bank acts as a
banker to their government which handle the accounts of
government departments and make short-term advances
to the government
 As a banker to banks : A bank at the end of a day’s
trading can run out of liquid assets to pay it owes or face
too many bad debts that may cause insolvent situation
--> Central bank acts as lender of last resort to avoid
banks from failure ( illiquid )
 Evaluation : Moral hazard exists --> Banks make risky
,high profitable activities --> the central bank will bail
them out
Activity 3 :
a) Monetary policy where the central bank buys financial assets in exchange for
money in order to increase borrowing and lending in the economy

b)QE helps increase in money supply and reduce interest rate. With reference to the
case, the purchase of assets would continue at a pace of about JPY 80 trillion a year.
The reduction in interest rate increase the demand for assets.Wealth effect exists as
the value of assets rises. The conumption and investment in Japan increases which
stimulates aggregate demand and brings up the inflation rate.