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Monetary Policy Target Interest Rate (D for credit) (Contractionary…
Monetary Policy
Target Interest Rate
(D for credit)
Market vs. Official Interest Rate
Market rate
driven by market forces of D&S
interest rate regarded as P of money
Official/ Central Bank lending rate
set by Central Bank, policy-driven
Central Bank is lender of last resort to commercial banks
change affects interest rates generally throughout economy
Nominal vs. Real Interest Rate
Nominal: before making adjustments for inflation
Real Interest Rate = Nominal Interest Rate - Inflation Rate
Expansionary Monetary Policy
to combat D-deficiency
Workings
Central Bank's rate below rate commercial banks charge customers
Commercial banks take advantage of cheap source of funds to create credit and provide more loans
Central Bank Rate:arrow_down: -> I:arrow_up: + C:arrow_up: + (X-M):arrow_up: -> AD:arrow_up:
I:arrow_up: as cost of borrowing:arrow_down:, MEI>r
C:arrow_up: as cost of borrowing for average household:arrow_down:, D:arrow_up: for cars etc, credit card spending & autonomous C:arrow_up:
interest rate lower than other major economies'
short term capital outflows to save with other banks for higher interest, :arrow_up:S of local currency in foreign exchange market
less capital inflow, :arrow_down:D for local currency
currency depreciates, net exports:arrow_up:
Limitations
Poor economic outlook
Do not wish to borrow
Firms may even downsize due to weak D
Fear of retrenchment :arrow_down: consumer confidence, withhold spending
Commercial banks not lending
Banks: borrowers defaulted, insufficient liquidity to provide loans
Consumers/Investors: exceeded borrowing limit, considered not creditworthy for fear of possible default
Nominal interest rate at/ close to zero
Unable to reduce further
Contractionary Monetary Policy
to reduce D-pull inflation
Workings
Central Bank's rate raised, commercial banks become more cautious and selective in lending,
Raise own rates to ensure higher cost of borrowing factored in their loans if they need to borrow from Central Bank
Limitations
Interest-inelastic C&I
Willing to into debt to splurge on cars & homes during economic boom
Inflation, expected returns may :arrow_up:, MEI shifts right
Negative real interest rate
nominal interest rate < inflation rate
borrowers benefit
especially in boom when inflation:arrow_up: faster than nominal interest rate
Revise interest rate gradually to prevent hard-landing
Contractionary Monetary Policy
to reduce BOT deficit
same as con. fiscal policy to reduce BOT deficit