Monetary Policy

Week 9 (final lecture of

MT)
Professor Dermot McAleese
 OUTLINE

 What is monetary policy?

 How does it affect economy?
 Effectiveness of Monetary policy
 Issues in Monetary policy
 MONETARY POLICY

 Primary target
 Intermediate targets
 Instruments
Primary target PRICE STABILITY

Intermediate targets

 Money supply
 Interest rates
 Exchange rate
Instruments
Direct:
 Interest regulations
 Credit controls
Market based:
 Discount rate
 Reserve ratio
 Open market operations
 INTEREST RATE

The interest rate is the amount of interest

paid per unit of time as a fraction of the
balance outstanding.

Fisher relation

REAL interest rate = NOMINAL

interest rate minus inflation
r=i-
 WHAT DETERMINES INTEREST RATES?
r
D1 S
D
r1
r
D1
D

A A1
I, S
r S
S1

E
E1 D
S
S1
I, S
INTEREST RATES AND ECONOMIC
ACTIVITY

 Substitution effect
 Income effect
 Wealth effect
 Investment effect
 MONETARY POLICY AND AGGREGATE
DEMAND
Substitution effect
(-) r  (-) S
 (+) C
Cash flow (income) effect
(-) r  (+) cash flow of borrowers
(-) r  (-) cash flow of lenders
Wealth effect
(-) r  (+) in asset values
(-) r  (+) C
 (+) I
 MONETARY POLICY AND AGGREGATE
DEMAND (Cont.)

CB credibility effect
(-) r  (+) domestic confidence in CB
(-) r  (-) domestic price and wage
increases

Exchange rate effect

(-) r  depreciation of real
exchange rate  (+) X, (-) M
 Expansionary monetary policy

Higher money base

Lower interest rate

Growing private sector credit

Asset price More spending More output

inflation in short run

Consumer price increase

Capacity
constraint/
tight labour
Inflation market
 MONETARY POLICY CAN SOMETIMES FAIL

• Problem 1: Keynes’ liquidity trap where nominal interest

rates fall to such a low level that no further cuts are
expected (LM curve flat)
• Problem 2: IS curve very steep, so outward shift of LM
affects interest rate but not output
• Problem 3: If prices are falling, the real interest interest
rate rises, investment is deterred. Since nominal interest
rates cannot fall below zero, central bank powerless. The
Japan case.
ISSUES in MONETARY POLICY

 Active vs. passive

 Rules vs. discretion
 CB as a supervisor
 Transparency vs. secrecy
Conclusions:

1. Conservative view: “How much do we really

know about monetary policy?
Enough to prevent it doing harm, but not
enough to use it to do good.”
David Laidler, Taking Money Seriously, 1996
2. Monetary policy an art not a science. Secret
lies in responding in timely way (compare Japan
and US)
3. So far counter-cyclical policies have
prevented major and prolonged depression.
Will this continue?