MACROECONOMIC

POLICIES AND PROBLEMS

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 MACROECONOMIC POLICIES
AND PROBLEMS

Managing the Economy

How?

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 Review

• Market economies have regular fluctuations in the

level of economic activity which we call the business
cycle.
• Govt use macroeconomic instruments to achieve its
goals: - output growth
- low unemployment
- price stability
• Failure to achieve these goals result in
macroeconomic problems:- unemployment
- inflation
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These problems become goals of macro policy.
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 MACROECONOMIC POLICIES
• Managing the economy
• Economic stabilization: managing business cycle
fluctuations.
• Economic policies used by government to smooth
out extreme swings of business cycles are called
countercyclical or stabilization policies,
• GDP = C(y) + I(r) + G + NX (r, e, y*)
• Policy instruments:- a) monetary policy - (r)
b) fiscal policy – (G and T)
c) trade policy – (e)
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 Monetary Policy
• Process by which the Central Bank, or
monetary authority of a country control
i) the supply of money,
ii) availability of money, and
iii) cost of money or rate of interest,
In order to attain a set of objectives oriented
towards the growth and stability of the
economy.
Recall:
• Md = f ( r, p, y)Thus – can be predictable
a relationship (stable)
exists between MS
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I = 01:59
f(r)PM and Investment through interest rate (r) 5
 The conduct of monetary policy
• Conducted by Central Bank.
• Policy setting environment
- Relationship between Govt and Central
Bank;
 Central Bank independence
(autonomy)
 Monetary policy committee

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 Role of Monetary Policy Committee (MPC)

• meets to consider latest news on the

country and global economy;
Interest rates
Consumer price inflation
Growth rate
At each of their meetings of interest rate
setting, the members of the MPC
consider a huge amount of information
on the state of the economy.
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Factors considered when setting Int. Rates

• GDP growth and output gap

• Bank lending and consumer credit figures
• Equity markets (share prices) and house prices
• Consumer confidence and business confidence
- ‘Leading indicators’ provide “advance warning”
of turning points in the economic cycle. -
• Unemployment figures
• Trends in global foreign exchange markets

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Factors considered when setting Int. Rates

• The key point is that the

Monetary Policy Committee
considers many indicators
from both the demand and
the supply side of the
economy.
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 Main effects of changes in interest rates?

Affect:
• Housing market & house prices
• Effective disposable incomes of
mortgage payers and savers
• Consumer demand for credit
• Business capital investment
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 Approaches to MP Implementation

• Instruments-intermediate
targets- ultimate objectives.
• Two approaches:-
a)Money supply targets
b)Interest rate targets
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 Monetary Policy – Review of Banking
• Fractional reserve banking system:-
Statutory vs Excess reserves
• Reserves market
- Central Bank reserves market
- interbank market
• Players in the money supply process
1. Central Bank
2. Banks
3. Depositors
4. Borrowers from banks
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 Monetary policy – Review of Banking
• Review on how bank create money:-
- Banks hold reserves (for legal reserve
requirement or unexpected large
withdrawals)
- Increase in reserves cause expansion of
bank lending that will increase money in
the form of deposits.
- Increase in MS lowers interest rates in the
money market.
- Decrease in reserves has opposite effect
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 Techniques for Monetary Policy

• Instruments or tools used to achieve MP

targets.

• CBs use their influence over bank

reserves to conduct MP.

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 Overview of Central Bank operation

RBZ balance sheet Consolidated balance sheet

• Assets Liabilities • Assets Liabilities
Govt securities Currency in circula Securities Deposits
Discount loans Reserves Reserves
Gold and SDRs Loans

The operation of the central bank and its

monetary policy involve actions that affect its
balance sheet, its holdings of assets and
liabilities.
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 What is monetary base
• is an important part of MS, because increases in it
will lead to a multiple increase in MS, ceteris paribus.

• Hence referred to as high powered money.

 MB = C + R (currency plus reserves)

Link of monetary base and money supply

MS = m * MB; m- money multiplier
Simple multiplier – 1/RR

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 Controlling the monetary base:
Instruments
Price based indirect instruments Quantity based direct instrument
• OMO • Moral suasion
• RR • Central bank direct
• DR (lender of last resort); lending
• Capital control
• Open mouth operations
(talking monetary policy
with the market).

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 OMO- Main MP tool

- Purchase & sale of govt

securities by the central bank.
• If Central bank is worried about
inflation appropriate MP:
tighten MS to increase interest rate.
• CB sells gvt securities.

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 Discount window
• aka discount rate policy (relatively minor tool)
• CB facility to lend funds to commercial banks
• Banks with insufficient reserves borrow reserves from CB.
• The rate of interest charged on borrowed reserves is
discount rate or interbank rate if borrowed from other
commercial banks.
• Changes in the cost of borrowing from either source will
have an impact on a wider range of interest rates.
• e.g. Decrease Disc rate – increase in borrowed reserves –
expansion of bank reserves – rise MS (thru multiplier) –
decrease interest rate.

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 Variable reserves requirement (RR)

• Relatively minor tool

• Banks required by law to hold a fixed fraction of deposits
as reserves; e.g. 10%, 20% for every amt of deposit.
• TR = LR + FR (total reserve = legal reserve + free
reserve)
• RR reduces the amt of loanable reserves
• CB can raise or reduce reserves
• Not very active policy because it is difficult to change RR
frequently.
• Changes in RR may have a destabilization effect in
the financial system.
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 Quantity based direct instruments

• Moral suasion
- cajoling certain market
players to achieve specified
outcomes
• Direct lending
• Capital control
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Monetary transmission channels

Operates in three stages

- ∆MS or MD → ∆i →affect I & C.
- ∆I, ∆C → shifts AD thus SR ∆s
in real GDP and the price level
(AD – AS model review).

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 Channels of monetary policy
• Credit Channel
• Interest Rate Channel
• Wealth Effect Channel
• Exchange Rate Channel

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 Channels of monetary policy
• Credit channel
- Bank rely heavily on dd deposits subjected to
RR as an important source of funding
economic activity.
- ∆RR → ∆BR → ∆CR →∆AD →inflation and
output
- Changes in reserve ratio affect the pool of bank
excess reserves which means less funds
available for credit to, this affect AD then output
and inflation
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 continued
• Interest rate channel
- ∆MS → ∆i → ∆real interest rates and the
cost of capital → interest sensitive
components of AD are affected.
- The policy induced ∆i would have a
significant impact on the level and pace of
economic activity.

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• Wealth effect channel
- ∆MS → ∆i → ∆ asset prices [ Pb = R/ (1+i)]
→∆wealth → ∆C or ∆I → output
- Policy induced changes in interest rates
affect the value of asset prices and
thereby the real value of consumer wealth
and this in turn leads to changes in
consumer spending.

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• Exchange rate channel (open economy
transmission)
- Links MP to GDP and inflation thru 2 routes:-
a) TOTAL DD: Policy induced changes in i
(domestic) relative to i*(foreign) (interest
differential) ↑ ∆i → capital inflow → ∆exc
(appreciates)→ ↓X → ↓AD → ↓ GDP → ↓infl
b) IMPORT PRICES: ∆i (domestic) → ∆exc → ∆
import prices → ∆ inflation

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 Schematic representation of monetary
transmission
Monetary Policy, Real GDP, and the Price Level: How Policy Affects the
Economy
Economic slump. 10000 ↑I→multiple
- Goal increase Real GDP effect on
GDP
Policy:- expansionary MP. 2000
(multiplier
- OM Purchase effect)
- Reduce RR
- Reduce discount rate • ↓i→↑I
low cost
Ms0 I
MM K.
Ms1 • Spending
↑Ms 20
shift on
curve 10 Md I
sensitive
to compone
Ms1. s of AD
i↓ 500 900 (dd
Analyse how money affect price level durable
goods)
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 The strength for monetary policy
• How effective is MP?
• Depends on the slopes of MD and I curves
- Impact on investment may be less than
traditionally thought. Despite interest rates of
zero, investment spending remained low
during the recession Zimbabwe (inelastic
investment demand).
• Speed and flexibility of MP
- can be quickly altered compared to fiscal
policy.
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 LR neutrality vs SR non-neutrality
LRAS SRAS
P3
P2 AD3
P1
P0 AD2
AD AD1
Q0 Q1 Y f Q2Q3
Recessionary gap Inflationary gap
- Effective in Keynesian region.
- Ineffective in Classical region (LR neutrality of
money).

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 Monetary policy in action:
challenges and issues
1. Stagflation
- Combo of stagnant real GDP & rising
inflation.
- Implying conflict of policy objectives.
- MP rendered ineffective.
2. Timing of the policy response.
• Recognition lag (identifying problem): shorter.
• Administrative lag (approving policy): shorter.
• Operational lag (policy to affect target): long.
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 Monetary policy in action:
challenges and issues
3. Less control
- Bank reforms & growth of e-transactions.
- Global financial flows
4. Changes in velocity
- Velocity may move counter to changes in MS.
5. Cyclical asymmetry may exist:
- Restrictive MP is effective to brake inflation,
- Expansionary MP not always effective in
stimulating the economy from recession.
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