Carried out by the central bank. The bank has a certain degree of independence from government interference. The independence ensures decisions are in the interest of long-term growth. There are trends around the world to make central banks more independent.
Objectives
Quite standard.
- Low and stable rate of inflation. We’ve seen how this is good in Inflation
- Low unemployment
- Reduce business cycle fluctuations
Inflation targeting
Beneficial since it grants stability for an economy. However, it can be disadvantageous since it reduces the capacity to achieve other macroeconomic objectives, seen in Relationship of Inflation and Unemployment. Here, we mean the inability to have lower rates of unemployment.
Determining interest rates
Monetary policies impact Aggregate Demand by manipulating interest rates. It is a simple 2-axis diagram with quantity of money at the bottom and the interest on the y-axis. The interest rate is not directly determined by the central bank — instead, they control the supply of money, allowing the market to determine the interest rate. hello diagram
Changing money supply
Minimum reserve requirements
When commercial banks take deposits, they must keep a percentage of the funds into required reserves. The fraction is called the minimum reserve requirement. Example for minimum reserve requirement. Its kind of like an infinite geometric sum. Changing this changes the money supply
Open market operations
Works by buying and selling pre-existing bonds. To increase money supply, simply buy bonds from commercial banks. To decrease money supply, sell bonds to commercial banks. The banks must buy them.
Central bank lending rate
This is the interest rate for commercial banks to borrow from the central bank. To increase money supply, decrease this interest rate. Conversely, vice versa.
Quantitative easing.
This is good enough to be a separate note. Quantitative Easing
Note: Real interest is nominal interest minus inflation rate.
Expansionary Monetary Policy
Increasing demand during times of contractions. Can visualize on both AS AD diagram and Keynesian. Note that the GDP increase will be larger in the Keynesian since the supply is flat.
Contractionary Monetary Policy
Decreasing demands during inflationary periods. Ratchet effect
Evaluation
Constraints
- Ineffectiveness in recession
- Interest rates generally cannot go below zero to further encourage spending.
- Low economic confidence anyways, they may not take out new loans regardless
- Banks may be fearful of lending, because of low confidence borrowers will pay back.
- May come in conflict with international objectives later.
- May be inflationary, especially if it lasts too long
- Of course, unable to deal with supply side things. Specifically, stagflation.
Strengths
- Fine-tunable interest rates
- Very reversible, flexible
- Relatively short time lags
- Central bank independence, no crazy corruption
- No debt
- No crowding out