Please enable JavaScript.
Coggle requires JavaScript to display documents.
Monetary Policy - Coggle Diagram
Monetary Policy
Goals of monetary policy
The maintenance of a low and stable rate of inflation is usually tied in with “inflation targeting” when the central banks set a specific medium-term target inflation rate
In March 2019, the Pakistan's central bank has increase its key rate to 10.75% from 10.25% overall raised 5% in one year. This contractionary monetary policy came in response to the inflation rate acceleration to 8.2% in February, overshooting the central bank's average forecast range of 6.5R to 7.5% for the year following the increase in price of petrol due to the significant devaluation of the Pakistani rupee. The main goal of the monetary policy is to decrease aggregate demand and stabilize the inflationary gap by raising interest rates and decreasing the money supply.
A low unemployment rate
In April of 2019, the Chinese central bank decided to fix the unemployment and recessionary economy caused by the Covid, which lead to a lockdown in many maior Chinese cities causing a decrease in spending and the worst unemployment rates since the start of the pandemic in March 2020. The Chinese central bank implemented expansionary monetary policy in the form of the "relending programme" a form of quantitative easing tool to provide funds for banks to land to sectors which include the ones hit by the pandemic. The quantitative expansionary policy is estimated in lead to $157 Billion in additional bank loans and is aimed to boost the economy and help during this recessionary gap.
-
-
-
Tools of monetary policy
Minimum reserve requirements:
The larger the minimum reserve requirement, the smaller will be the money multiplier. This means that if the government wants to reduce the money supply (a contractionary monetary policy) then they should increase the minimum reserve requirement. This would reduce the ability of the banks to create credit and so will reduce the money supply. This will increase interest rates and thus lower AD as consumption and investment fall. On the other hand, if they want to increase the money supply (an expansionary monetary policy) then they would do the opposite.
Open market operations:
It involves the buying and selling of government securities in the open market by the central bank. Government security is a bond that offers interest on the nominal value of the bond. They are very low-risk since they are guaranteed by the government. If central banks want to reduce the money supply (contractionary monetary policy), then they will sell more government securities to institutions, which will reduce the money that commercial banks lend. This will increase the cost of borrowing and so increase interest rates, the price of money.
Changes in the central bank minimum lending rate:
This is known as the base rate. It’s the rate of interest that the central bank charges on loans and advances to commercial banks. It operates as the base rate for the banking system, influencing the interest rate charged on bank loans, mortgages and etc… The central bank has control over the minimum lending rate so they can change it as they wish. If the bank is implementing a contractionary monetary policy, it will increase the minimum lending rate. This will discourage consumers and businesses from borrowing money and encourage them to save more. This will decrease AD as consumption and investment decrease.
Quantitive easing: It involves the introduction of new money into the money supply by a central bank in order to expand the economy. The process involves the central banks injecting new money directly into the economy by purchasing assets from commercial banks and other financial institutions with newly created electronic cash.
Types
Expansionary
Expansionary monetary policy is used to increase AD. To do so, central banks might lower the base rate of interest. This would reduce the cost of borrowing and could lead to an increase in both consumption and investment. They could also increase the supply of money, which would lower its price since the interest rate is the price of money. The expansionary policy involves a “trade-off” between lower unemployment and higher inflation.
Contractionary
Contractionary monetary policy is used to decrease AD. To do so, central banks might increase the base rate of interest. This would increase the cost of borrowing and could lead to a decrease in both consumption and investment. They could also decrease the supply of money, which would increase its price since the interest rate is the price of money.
Effectiveness
Strengths
-
There is no political intervention as banks are independent of the government (this is the opposite of fiscal policy)
An absence of “crowding out”: fiscal policies involve increasing government borrowing, which might lead to higher interest rates and a “crowding out”.
The ability to make small changes: monetary policy is more precise than fiscal and set more specific goals/targets because interest rates may be adjusted by a little bit.
Limitations
-
Ineffectiveness when interest rates are low: interest rates will eventually start to approach 0 and there will be no room left for further cuts.
Low consumer and business confidence: the effect on expenditure may be very much dampened by low consumer and business confidence. This is especially the case if the economy is in a deep recession.
-
-
-
-