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2.4Di How Monetary Policy Works Pages 181 + 233-235
Recall Monetary Policy… • It occurs when the government attempts to control the money supply in order to influence interest rates (r): • One of two types of __________-________ policy • Expansionary monetary policy - Increase the money supply, which results in lower r, thus increasing C, I and X • Thus AD… • Contractionary monetary policy- Decrease the money supply, which results in higher r, thus decreasing C, I and X • Thus AD… • What 3 macro-objectives are affected by this policy?
Enter: the central bank • Owned and operated by central government of a country. (The Reserve Bank of New Zealand (RBNZ), the FED, etc.) • It is designed to oversee the banking system to promote safe and sound banking practices. • It acts as a banker’s bank, making loans to banks and as a lender of last resort. • It is the central government’s bank. • Some have the sole macro-objective to keep inflation between 1 – 3% in the medium term. • Other central banks may do this more implicitly, or also have other macro-objectives simultaneously. • Stablising exchange rates • Stablising growth rates
Money supply Equilibrium interest rate Money demand M1 Quantity fixed Quantity of M1 by the Reserve Bank Money Monetary Policy in Action Interest rate r1 r2 0
MS’ r’ PL’ AD’ 2. The higher interest rate discourages investment, exports and consumption. 3. AD will decrease and shift to the left, reducing inflationary pressure 1. Reserve bank decreases MS, which results in a higher interest rate How Contractionary Monetary policy works interest MS Price Level LAS AS PL Inflationary gap r AD Real GDP
Evaluating monetary policy Since 1990 CPI inflation has averaged around 2.5%. This compares with averages of around 12% in the 1970s and 11% in the 1980s.
The pros: • Simple and cost effective to administer • “transparent” process is seen as fair • A powerful way to control growth • Quite successful in most countries The cons: • Time lags of 12-18 months makes timely implementation difficult to determine (based upon previous year’s indicators) • Time lags make size of impact difficult to predict • Other factors influencing I, C will interfere with the impact (i.e. what if confidence is TOO low or high?) • Contractionary policy is always unpopular(of course)