Monetary Policy

Monetary policy are the manipulation of the money supply and interest rate by the central bank to influence the borrowing of money and thereby the level of AD What is: – Central bank? – Money? Any medium that is acceptable as payment for goods and services – Interest rate? It is the price/cost of borrowing money which depends on length of time of borrowing, size of loan, inflation rate, etc. (risk and uncertainty involved with time) – The interest rate is determined using the usual Demand and Supply for the money/loanable funds market

Nature of work of financial analysts and central bank officials

Increasing the MONEY SUPPLY Quantitative Easing and ways of influencing amount of lending done by BANKS Equation: MV ≡ PT ( or PQ or PY or Nominal GDP) SO will an increase in M  increase in P? YES if…………………………………………………

Equilibrium Interest Rate and Money Supply

Monetary base in Japan

Short Term Interest Rate (for lending)

How interest rate affects AD Changes in interest rates ultimately affect two of the four components of aggregate demand – Consumption (C): e.g. large purchases that require borrowing like cars, houses, university tuition, etc. – Investment (I): e.g. building a new factory, purchasing a very expensive inventory and machine that will likely to increase future production

Which D-side policy is more effective? Fiscal Policy – Pro: can pull economy out of recession (e.g. Great Dep ‘30; – ability to target sectors (e.g. spending on education, infrastructure) with some supply side effects – Con: time lags; hard to forecast and calculate their impacts;; hard to target and fine tune as AD determined by multiple factors; – crowding out Monetary Policy – Pro: quick implementation; independence from political constraints; no crowding out; can adjust interest rate incrementally and flexibly – Con: time lags; effective on inflation but not so during recession (pulling on a string) ; international impacts (effects on exchange rates, access to foreign lending);

Summarising It is not a simple and easy task to achieve the desirable macro-economic outcomes During the 1980s a lots of economists studied macroeconomic dynamics and management But inflation/deflation, unemployment, inconsistent GDP growth persist Moreover, financial crisis on the scale of the 1930s Great Depression continues to happen i.e. the recession after the Lehman Shock

To sum, Is it such an easy task? Not quite so … One intervention has multiple/multivariate channels & mechanisms in affecting the various demand components. Like a big “Knot”…human behavior is complex and dynamic! – Ceteris paribus is critical! But in the dynamic reality, hard to make such assumption and therefore hard to predict and forecast and it can get out of control! The multiplier effect – The national income will/should increase more than how much the government will spend as the increase in spending circulates the economy The two schools of thought – Quite different on the implications on price and real GDP level (monetarist believe no effects on real GDP, only on avg prices) We considered only the Demand Side, also need to consider the Supply Side Policies