Macroeconomics

Monetary policy 1
Program
• Recap from last time
• Key concepts
• Today’s reading
+ HL only topics
+ SL Exercises

• Exam practice questions

Recap from last time
• What were the most important points from last module?
 Key concepts
• Monetary policy • Credit creation
• The Central Bank • Minimum reserve ratio
• Interest rate • Money multiplier
• Demand-side policy • Open market operations
• Money supply • Liquidity trap
• Inflation targeting • Quantitative easing
• The external balance
 • The use of interest rates and the
Monetary supply of money to influence the
level of aggregate demand and

policy economic activity, in order to

achieve the country’s macroeconomic
objectives.
 • Any government strategy or plan to
Demand-side influence the level of aggregate
demand, such as reducing interest

policy rates to reduce the cost of

borrowing money to finance
household consumption expenditure
(C) and corporate investments (I).
 • The price of money, or how much it
Interest rate costs to use someone else’s money.
The interest rate is not only
influenced by market forces, but
also by the decisions of central
banks.
Role of the Central Bank
1. Executor of monetary policy

2. Government’s bank

3. Bankers’ bank

4. Sole issuer of legal tender

5. Lender of last resort

6. Credit control
Goals of monetary
policy
1. Low and stable rate of inflation
2. Low unemployment
3. Reduce business cycle
fluctuations
4. Promote a stable economic
environment for long-term growth
5. External balance (X – M)
+ Lower IR tends to make a currency
less attractive , thereby reducing
the exchange rate. This will increase
X, which will affect inflation
Money demand
• Money demand
1. The purchase of goods and services (transaction demand)
a. Relatively autonomous of interest rates and more determined by income
2. Money as an asset (asset or speculative demand)
a. Inversely related to the interest rate

• Transaction demand + Asset demand = Dm, Total demand

Demand of money
• The desire to hold money to
finance consumption
+ Higher interest rate
• Less demand, but higher
incentive to save
+ Lower interest rate
• More demand, but lower
incentive to save
Money supply
• The money supply is independent from changes to nominal interest rates as it is
determined by CB’s

• The vertical Sm curve

+ Price increases (IR increases) do not affect the supply of money. It is completely
inelastic

• By determining the supply of money, Central Banks can influence nominal interest
rates and affect consumption and investments in the economy
Supply of money
• Money supply, which is
controlled by the CB,
determines the interest rate
+ Less money
• Higher interest rate
+ More money
• Lower interest rate
SL Questions
• Define the term monetary policy.

• Define the term interest rate.

• Explain the phases of the business cycle.

• Explain how the government can use monetary policy to alter the level of AD in
the economy.

• Using an AD/AS diagram, explain how “monetary policy tightening” may affect a
country’s inflation rate.
Creation of
money (HL)
• Credit creation: The process by
which commercial banks create
money from deposits from savers
and use these funds as loans to
borrowers.

• MRR:

• Money multiplier:
Tools of monetary policy (HL)
• OMO
+ Buying and selling of gov’t bonds

• MRR
+ The percentage of deposits a bank must hold or deposit in the CB, affects the credit
creation/money multiplier

• Discount rate
+ The official interest rate charged by the central bank on loans to commercial banks
Quantitative
easing
• Explain how QE works and when
it is considered an especially
useful tool
Real and nominal interest rates
• Nominal interest rate: The actual rate that is agreed between a lender and a
borrower

• Real interest rate: NIR - Inflation

HL Questions
• Define the terms Money and interest rates

• What is the role of central banks and why are they governed independently from
party politics?

• How can central banks help economies achieve some of the key macroeconomic
objectives?

• Explain how changes in interest rates can influence the level of aggregate demand
in an economy.
Next time
• Read pp. 372-379