Cae 24 Demand management (demand- side policies) — monetary policy Real-world issue How do governments manage their economy and how effective are their policies?SYLLABUS CONTENT By the end of the chapter, you should be able to understand: monetary policy, with reference to control of the money supply and interest rates by the central bank (AO1) the goals of monetary policy (AQ2) the process of money creation by commercial banks (AO2) (HL only) the tools of monetary policy (AO2) (HL only) the demand and supply of money, with reference to the determination of equilibrium interest rates (AO2) (HL only) a diagram to show the determination of equilibrium interest rates (AO4) (HL only) the difference between real and nominal interest rates (402) interest rates from given data (AO2) the use of expansionary and contractionary monetary policies to close deflationary/ recessionary and inflationary gaps (AO3) a diagram using AD-AS curves to show expansionary and contractionary monetary policy (AO4) the effectiveness of monetary policy, with reference to constraints on monetary policy and the strengths of monetary policy (AO3) the strengths and limitations of monetary policy in promoting growth, low unemployment, and low and stable rates of inflation (AQ3).Monetary policy (AO1) About Monetary Policy of Monetary policy is the process by which monetary ELA Tee Rae ee Meee Ca AM ete ee ee controls the supply of money in the economy by roe rer s control over interest rates in order to PIT eTTiMe uCeComaesL oT haere te Meo nT Come Tab Mmcree ype te growth.Monetary policy refers to the government's control and use of interest rates and the money supply to influence the level of aggregate demand and economic activity, Like fiscal policy (see Chapter 25), monetary policy as a demand-side policy is discretionary in nature, thatis, itis purposively carried out by the government to influence the level of aggregate demand and economic activity. In practice, monetary policy is overseen by the nation’s central bank or designated monetary authorityExpansionary and Deflationary Monetary Policy Expansionary Deflationary Monetary Policy Monetary Policy Fall in nominal and real Higher interest rates on level of interest rates: both loans and savings Measures to expand the Tightening of credit supply supply of credit from the (i.e. loans become harder banking system to get) Depreciation of the external value of the exchange rate Appreciation of the exchange rateInterest rates are the price of money. Interest rates can refer to the price of borrowing money (the interest rate charged to borrowers) or the return from saving money (the interest rate paid to savers) at financial institutions, such as commercial banks. A demand-side policy refers to any government strategy or plan to influence the level of aggregate demand, such as reducing interest rates to reduce the costs of borrowing money to finance household consumption expenditure (C) and corporate investments (|). The money supply refers to the entire quantity of money circulating in an economy, including notes and coins, loans and savings deposits at financial institutions and banks.Functions of a central bank (monetary authority) = Executor of monetary policy — In most countries, the central bank or the country's monetary authority is responsible for managing interest rates and the exchange rate (for its currency) in order to achieve macroeconomic objectives. = Government's bank — The central bank is responsible for the money of the government, including its foreign currency reserves. It maintains the accounts of the government in the same way that commercial banks maintain the accounts of their private and corporate customers. = Bankers’ bank — The central bank is the regulator of the country’s commercial banking system. For example, commercial banks must keep a certain percentage of their cash reserves at the central bank so it can control the money supply in circulation and/or use the reserves in times of financial emergencies.= Sole issuer of legal tender — As the supreme bank, the central bank or monetary authority is the sole issuer of legal tender (bank notes and coins) within the country. This helps to control the money supply and brings uniformity and confidence to the monetary system. = Lender of last resort — The central bank provides loans to commercial banks when necessary to prevent the risks of a financial crisis caused by limited cash reserves and liquidity problems. Thus, as lender of last resort, the central monetary authority helps to ensure the banking system runs smoothly. = Credit control — By controlling the cash reserves that commercial banks must hold at the central bank, credit creation is managed more effectively. For example, the central bank could raise the cash reserve ratio during an economic boom to limit over-lending by commercial banks.OBJECTIVES OF MONETARY POLICY The following are the principal objectives of monetary policy: Full Employment Price Stability Economic Growth Balance of Payments Exchange Rate Stability Neutrality of Money Equal Income Distributionm= Low and stable rate of inflation targeting) Like fiscal policy, governments use monetary policy to either expand or contract economic activity to achieve their macroeconomic goals. For instance, interest rate policy and manipulation of the money supply can be used to achieve a low and stable rate of inflation. An inflation rate target (OF inflation targeting) refers to the practice of central banks in some countries (such as Canada, Finland, New Zealand, South Africa and the UK) to use monetary policy to achieve a specific rate of inflation. An inflation target is used to provide a transparent goal in order to help control inflation to enable sustainable economic growth and employment. This is because price stability will enhance consumer and business confidence in the economy.um Low unemployment It is ultimately the role of the government, rather than a monetary authority or central bank, to focus on achieving and maintaining full employment However, monetary policy can be used to help achieve low unemployment Lower interest rates, in theory, should stimulate economic activity by increasing aggregate demand. This is because lower interest fates reduce borrowing costs for households and firms, thereby helping to boost consumption and investment, ceteris paribus. Figure 24.2 shows that lower interest rates encourage consumption spending (C) and investment expenditure (I), boosting aggregate demand from AD, to AD,. As national output increases from Y, to Y,, this should reduce the number of people in unemployment.General price level Real GDP m@ Figure 24.2 Effects of lowering interest ratesmu Reduce business cycle fluctuations Monetary policy is a key demand-side policy used to influence the level of economic activity. Lower interest rates can be used during an economic downturn in the business cycle (see Chapter 16), as illustrated in Figure 24.2. By contrast, if the economy is booming, as shown in Figure 24.3, higher interest rates can be used to reduce the impact of inflationary pressures especially if the country is near to or at full employment (Y;). Higher interest rates, in theory, shift aggregate demand from AD, to AD, thereby helping to keep inflation under control by reducing the general price level to fall from PL, to PL.General price level PL, Y1Y¢ @ Figure 24.3 Effects of raising interest rates Real GDP& Promote a stable economic environment for long-term growth Economic stability, through the use of monetary policies, makes it easier to achieve macroeconomic objectives, such as stable prices, lower unemployment and sustainable economic growth. This is because economic stability creates a greater degree of certainty and confidence for consumers and firms. Hence, by stabilizing fluctuations in the business cycle, effective use of monetary policy helps to encourage investments in physical and human capital for long-term growth of the economy.