eco2013 (6) - principles of economics: macro unit 9 study guides

Key Concepts

• Monetary policy involves central banks' actions to influence money supply and interest rates to achieve macroeconomic goals (price stability, economic growth, full employment)
• Money supply consists of currency in circulation and deposits held by banks
• Interest rates represent the cost of borrowing money and the return on savings
  • Higher interest rates encourage saving and discourage borrowing and spending
  • Lower interest rates stimulate borrowing, investment, and economic growth
• Inflation measures the rate of increase in the general price level of goods and services
  • Central banks aim to maintain low and stable inflation (typically around 2%)
• Monetary policy transmission mechanism describes how changes in monetary policy affect the economy through various channels (interest rates, credit, asset prices, exchange rates)
• Liquidity refers to the ease with which an asset can be converted into cash without affecting its market price
• Open market operations involve central banks buying or selling government securities to influence money supply and interest rates

Monetary Policy Tools

• Open market operations are the primary tool used by central banks to implement monetary policy
  • Buying securities increases money supply and lowers interest rates
  • Selling securities decreases money supply and raises interest rates
• Reserve requirements set the minimum amount of reserves banks must hold against their deposits
  • Higher reserve requirements reduce banks' lending capacity and money supply
  • Lower reserve requirements increase banks' lending capacity and money supply
• Discount rate is the interest rate charged by central banks on loans to commercial banks
  • Raising the discount rate makes borrowing more expensive for banks, reducing lending and money supply
  • Lowering the discount rate encourages borrowing and increases money supply
• Interest on reserves is the rate central banks pay on banks' reserve balances
  • Higher interest on reserves incentivizes banks to hold more reserves, reducing lending and money supply
• Forward guidance communicates central banks' intentions about future monetary policy to influence market expectations and long-term interest rates
• Quantitative easing involves central banks purchasing long-term securities to lower long-term interest rates and stimulate economic activity during crises or when short-term rates are near zero

Central Banks and Their Role

• Central banks are responsible for conducting monetary policy to achieve macroeconomic objectives
  • Examples include the Federal Reserve (US), European Central Bank (EU), and Bank of Japan
• Independence from political influence allows central banks to make decisions based on economic considerations rather than short-term political pressures
• Dual mandate refers to the Federal Reserve's responsibility to promote both price stability and maximum employment
  • Other central banks may have a single mandate focused on price stability
• Lender of last resort function means central banks provide liquidity to the financial system during crises to prevent widespread failures and maintain stability
• Central banks conduct economic research and analysis to inform monetary policy decisions and assess the state of the economy
• Transparency and communication are crucial for central banks to manage market expectations, enhance policy effectiveness, and maintain accountability
  • Regular press conferences, minutes of policy meetings, and economic projections help communicate central banks' views and intentions

Money Supply and Demand

• Money supply is determined by central banks through monetary policy tools and the behavior of commercial banks and the public
  • M1 includes currency in circulation and demand deposits
  • M2 includes M1 plus savings deposits, money market funds, and small time deposits
• Money demand represents the public's desire to hold money for transactions, precautionary, and speculative purposes
  • Influenced by factors such as income, interest rates, and expectations about future economic conditions
• Quantity theory of money states that changes in money supply lead to proportional changes in the price level, assuming constant velocity of money and full employment
• Money multiplier describes how an initial deposit can lead to a larger increase in the money supply through the process of bank lending and re-depositing
  • Determined by the reserve requirement and the public's preference for holding currency versus bank deposits
• Velocity of money measures the average number of times a unit of money is used to purchase goods and services in a given period
  • Higher velocity indicates more frequent transactions and can contribute to inflation if money supply is not controlled
• Liquidity preference theory explains the public's demand for holding money based on the trade-off between the liquidity of money and the interest earned on other assets

Interest Rates and Economic Impact

• Interest rates represent the cost of borrowing and the return on savings, influencing consumption, investment, and economic growth
• Short-term interest rates are directly influenced by central banks' monetary policy decisions
  • Examples include the federal funds rate (US) and the main refinancing rate (EU)
• Long-term interest rates are determined by market forces and expectations about future short-term rates and inflation
  • Examples include yields on government bonds and mortgage rates
• Higher interest rates discourage borrowing and spending, reducing aggregate demand and inflationary pressures
  • Can lead to slower economic growth and higher unemployment in the short run
• Lower interest rates encourage borrowing, investment, and consumption, stimulating aggregate demand and economic activity
  • Can lead to faster economic growth and lower unemployment but may also fuel inflation if not managed carefully
• Monetary policy transmission channels include the interest rate channel, credit channel, asset price channel, and exchange rate channel
  • These channels describe how changes in monetary policy affect various aspects of the economy and influence overall macroeconomic conditions

Inflation and Price Stability

• Inflation is the sustained increase in the general price level of goods and services over time
  • Measured by price indices such as the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) index
• Price stability refers to a low and stable rate of inflation, typically around 2% for most central banks
  • Helps maintain the purchasing power of money and facilitates long-term planning and investment
• Demand-pull inflation occurs when aggregate demand grows faster than aggregate supply, putting upward pressure on prices
  • Can be caused by factors such as increased government spending, lower taxes, or higher consumer confidence
• Cost-push inflation occurs when production costs rise, leading to higher prices for goods and services
  • Can be caused by factors such as rising raw material prices, higher wages, or supply chain disruptions
• Hyperinflation is an extremely high and accelerating rate of inflation, typically over 50% per month
  • Often results from excessive money supply growth and a loss of confidence in the currency
• Deflation is a sustained decrease in the general price level, which can be damaging to the economy by discouraging spending and investment
  • Central banks aim to avoid deflation by maintaining a low but positive inflation rate

Monetary Policy Strategies

• Inflation targeting involves setting an explicit numerical target for inflation and adjusting monetary policy to achieve that target over the medium term
  • Helps anchor inflation expectations and enhances central bank credibility
• Price level targeting aims to keep the price level close to a predetermined path, making up for past deviations from the target
  • May require more aggressive policy actions compared to inflation targeting
• Nominal GDP targeting focuses on achieving a target level or growth rate of nominal GDP, which accounts for both inflation and real economic growth
  • Automatically adjusts for supply shocks and may provide better macroeconomic stability
• Taylor rule is a guideline for setting interest rates based on deviations of inflation from its target and the output gap (difference between actual and potential GDP)
  • Provides a systematic approach to monetary policy but may not account for all relevant factors
• Unconventional monetary policy refers to tools used when short-term interest rates are near zero and traditional policies are less effective
  • Includes quantitative easing, forward guidance, and yield curve control
• Rule-based versus discretionary monetary policy debate centers on whether central banks should follow predetermined rules or have flexibility to respond to changing economic conditions
  • Rules provide predictability and accountability, while discretion allows for adaptability to unforeseen circumstances

Real-World Applications and Case Studies

• The Federal Reserve's response to the 2008 Global Financial Crisis involved lowering interest rates to near zero and implementing quantitative easing to stabilize financial markets and support economic recovery
• The European Central Bank's Outright Monetary Transactions (OMT) program, announced in 2012, helped reduce sovereign debt crisis pressures in the eurozone by committing to purchase government bonds of member states facing financial distress
• Japan's experience with deflation and the Bank of Japan's efforts to overcome it through quantitative easing and yield curve control highlight the challenges of conducting monetary policy in a low-growth, low-inflation environment
• The Swiss National Bank's decision to remove the Swiss franc's peg to the euro in 2015 demonstrates the risks and limitations of fixed exchange rate policies and their impact on monetary policy autonomy
• The Federal Reserve's "taper tantrum" in 2013, when markets reacted strongly to the announcement of a potential reduction in asset purchases, underscores the importance of clear central bank communication and the impact of monetary policy expectations on financial markets
• The COVID-19 pandemic has led central banks worldwide to implement unprecedented monetary policy measures, such as large-scale asset purchases and direct lending to businesses, to support economies facing simultaneous supply and demand shocks