+ Demand-side Policies: Monetary Policy Part I IB Economics – Mr. Padula April 2012

+ IB Syllabus: Interest Rate Determination and the Role of the Central Bank  Describe the role of central banks as regulators of commercial banks and bankers to governments  Explain that central banks are usually made responsible for interest rates and exchange rates in order to achieve macroeconomic objectives  Explain, using a demand and supply of money diagram, how equilibrium interest rates are determined, outlining the role of the central bank in influencing the supply of money

+ IB Syllabus: Monetary Policy and Short-Term Demand Management  Explain how changes in interest rates can influence the level of aggregate demand in an economy  Describe the mechanism through which easy (expansionary) monetary policy can help an economy close a recessionary gap  Construct a diagram to show the potential effects of easy (expansionary) monetary policy, outlining the importance of the shape of the aggregate supply curve

+ IB Syllabus: Monetary Policy and Short-Term Demand Management  Describe the mechanism through which tight (contractionary) monetary policy can help an economy close an inflationary gap  Construct a diagram to show the potential effects of tight (contractionary) monetary policy, outlining the importance of the shape of the aggregate supply curve

+ IB Syllabus: Evaluation of Monetary Policy  Explain that central banks of certain countries are guided in their monetary policy by the objective to achieve an explicit or implicit inflation rate target  Evaluate the effectiveness of monetary policy through consideration of factors including: The independence of the central bank The ability to adjust interest rates incrementally The ability to implement changes in interest rates quickly Time lags Limited effectiveness in increasing AD during recession Conflict among government economic objectives

+ The Role of the Central Bank Implement monetary policy Money Supply Interest Rates/Exchange Rates Promote the stability of the banking/financial system Manage the production and distribution of currency “Bankers’ Banker” and Regulator of Banks Central Banks include: European Union Central Bank United Kingdom – Bank of England United States – Federal Reserve System (the “Fed”) Canada – Bank of Canada

+ The Market for Money: How is the Interest Rate Determined? Interest = The “Price” of Money = The Opportunity Cost of holding money The Demand for Money is downward-sloping: As the rate of interest falls, the demand for money increases If the Supply of Money is fixed, then the Demand for money determines the rate of interest If the Central Bank shifts the supply of money, then the interest rate is affected

+ Monetary Policy Monetary Policy: A change in interest rates… A change in Consumption (C) and Investment (I); (note: affects I more than C) A change in Aggregate Demand (AD) A change in Real GDP and/or the Price Level (Note: The effect will differ based on Classical v. Keynesian approach) Recessionary Gap? Expansionary (Easy) Monetary Policy  Lower Interest Rates Increase C and I  Shift AD to the right Inflationary Gap? Contractionary (Tight) Monetary Policy  Raise Interest Rates Decrease C and I  Shift AD to the left

+ Time to Draw! Show how Expansionary Monetary Policy would work during an recessionary gap: Neoclassical modelKeynesian model

+ Time to Draw! Show how Contractionary Monetary Policy would work during an inflationary gap: Neoclassical modelKeynesian model