Monetary Policy

Interest Rate

An interest rate is the rate at which interest is paid by borrowers (debtors) for the use of money that they borrow from lenders (creditors).

Interest Rate

The opportunity cost of spending money. Can also be referred to as the cost of money. Ex. When firms or households borrow money from a bank, they must pay back more than the amount borrowed.

Contractionary Monetary Policy

When the central bank manipulates the money supply in hopes of decreasing real GDP in the nation. This can be done by increasing reserve rates, selling bonds, and increasing discount rates.

Inflation control strengths

-Direct action with speed and control. -Because directors of the central bank are not voted in by the population, their policies will not revolve around the wants of the people, instead, they will focus on economic data and facts.

Stimulating growth during a recession weaknesses

-Sometimes, when a nation is stuck in a recession, investors will be reluctant to borrow money despite lower interest rates while consumers will be more willing to save their money rather than spending it. This can create a lingering recession. -Although monetary policy is fast to implement, it may take time to show signs of improvement in the economy depending on the elasticity of demand in the country. -Changing demand elasticities can also be a weakness of monetary policy as these changes could cause unexpected fluctuations in the rGDP.

Stimulating Growth during a recession Strengths

-The decision to change money supply rests on the hands of the central bank and can be enacted as soon as any problem is found. This makes the process very fast. -There is more control from the central bank. They are able to decrease and increase money supply more precisely. -The central bank is independent from politics, making the process very fast as they bypass the voting aspect of politics. This can also lower risk of corruption. -There is no crowding out because monetary policy works to decrease interest rates when trying to increase rGDP.

Inflation control weaknesses

-There can be time lags during high inflation. -Powerless against cost push (supply side) inflation.

Bonds

A bond is a certificate issued by the government which guarantees repayment of certain amounts charged with added interest. Essentially, a bond is an "I owe you" (IOU). When a central bank wishes to enact an expansionary monetary policy, they will tend to buy bonds from the government, which would increase money supply and lower interest rates. On the other hand, during a contractionary policy, the central bank would sell bonds, lowering money supply and increasing interest rate.

Monetary Policy

A macroeconomic policy enacted by the central bank that involves the management of money supply and interest rates. This policy is often used to stimulate growth, control inflation and manage exchange rates.

Tools for changing money supply

Changing the discount rate, buying or selling bonds, changing the reserve requirement.

Central Bank

The central bank is charged with the task of manipulating the money supply in a certain nation in order to meet economic goals. However, these goals sometimes conflict each other.

Discount Rate

The discount rate is the rate charged by central banks when they make loans to big commercial banks. This is primarily used to send signals to commercial banks on whether or not they should increase or decrease their lending activities. For example, if the discount rate is low, commercial banks will most likely increase their lending activities. In turn, money supply would increase and interest rates are also likely to decrease.

Reserve Requirement

The reserve requirement is a percentage of deposits that banks are required to have available at all times. If reserve requirements are low, banks are able to lend more of their excess reserves which would increase money supply and decrease interest rates. While a high reserve requirement would decrease money supply and increase interest rates.

Expansionary Monetary Policy

When the central bank manipulates the money supply in hopes of increasing real GDP (stimulate growth) in the nation. The central bank can do this by decreasing reserve requirements, buying more bonds or lowering discount rates.

Effect of decreasing interest rate

When the interest rate decrease due to monetary policy, quantity of investment is likely to increase since money is cheaper to borrow. This will raise aggregate demand and rGDP towards inflation.

Effect of increasing interest rate

When the interest rates within a nation increases due to monetary policy, the quantity of investment in that country is then expected to decrease as it becomes more expensive to borrow money. This in turn will shift aggregate demand to the left towards a recession, lowering rGDP.