The aims of monetary policy

Governments have different economic tools they can use to target their macroeconomic objectives:

• Sustainable economic growth
• Low unemployment
• External balance on the current account balance of payments
• Low inflation or price stability

The government can use demand management or a demand-side approach where it affects aggregate demand in the economy to achieve these objectives. The government demand management approach can be broken down into monetary policy and fiscal policy. This chapter considers how monetary policy can be used to try and achieve the government's macroeconomic objectives.

Understanding monetary policy

Monetary policy is where the government uses interest rates and the supply of money to achieve its macroeconomic objectives. For example, the central bank of a country uses interest rates and the supply of money to manage the rate of inflation.

Importance of the central bank

Haruhiko Kuroda - Head of the Bank of Japan

The central bank in an economy is the key institution the government uses to apply monetary policy. In the US the central bank is the Federal Reserve, in the EU it is the European Central Bank and in Japan, it is the Bank of Japan. In recent years many countries have made their central bank independent from the government so it can apply monetary policy without too much political influence on decision-making. The central bank applies monetary policy by using the following tools:

• Base interest (discount) rates
• Quantitative easing
• Open market operations
• Minimum reserve requirements

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Determining the supply of money - credit creation (HL)

Credit creation is the way commercial banks in an economy create money from the funds deposited with them. Credit creation has an important influence on the money supply of the economy and the way monetary policy works. The process of credit creation is based on the following assumptions:

• One bank represents the whole banking system. In reality, the banking system is dominated by a number of large banks, but in this model, the whole banking system is considered to operate as one bank.
• The firms and households that deposit money in banks will only withdraw a certain proportion at any one time to make transactions. This is realistic if you think about the way most people use their money. For example, we can assume that most customers will only withdraw 20 per cent of their deposit at any one time.
• A minimum reserve asset ratio requirement is set based on the withdrawal rate of the bank's customers. In this case, it is 20 per cent.
• The money withdrawn from the bank will be redeposited bank in the bank and not held outside the banking system.
• Banks make a profit by charging a higher rate of interest to borrowers than they pay to depositors. Thus, banks have an incentive to lend as much as it is safe for them to do.

The credit creation process

Based on these assumptions This is how credit creation works in an economy where a single bank represents the whole system:

Step 1 An initial deposit of $200,000 in cash is put into the bank.

Step 2 The bank can use the $200,000 as a 20% reserve asset to cover cash withdrawals. In this case, it will use $40,000 of the initial $200,000 deposit to cover withdrawals from the customer who made the $200,000 deposit. The remaining $160,000 can be used to cover cash withdrawals from any loans the bank makes.

Step 3 An individual asks for a loan from the bank to buy a house for $200,000. The banks will make this loan because they can use $40,000 of the $200,000 initial deposit as a 20 per cent reserve to cover a withdrawal that might occur from the $200,000 loan made. After the loan is made and the borrower buys the house, the individual they bought the house from will deposit the $200,000 back in the bank. As a result of this, the bank has created $200,000 of credit and this money is now circulating in the economy.  

Step 4 A firm applies for a $600,000 loan from the bank to buy a new machine. The bank has $120,000 of the initial deposit left ($200,000 - $80,000) to cover the 20% reserve asset ratio requirement for the loan for the $600,000 machine. Another $600,000 has been created with this loan so the total amount of credit creation of is $800,000 ($200,000 + $600,000).

Step 5 The bank will not make any new loans now because it has reached its 20% reserve asset ratio limit where it has $200,000 backing $1,000,000 of funds ($200,000 initial deposit + $200,000 house loan + $600,000 machine loan).

The money multiplier

The money multiplier is the amount of credit that can be created from a certain quantity of money deposited. The money multiplier can be calculated by using the equation:

1 / minimum reserve requirement = money multiplier

1 / 0.2 = 5

5 x $200,000 = $1,000,000

This example of credit creation shows how an increase in bank deposits of $200,000 can lead to a $1,000,000 ($200,000 deposit plus $800,000 created credit) increase in the money supply when the reserve asset ratio is 20 per cent.

Interest rates

The influence of the base rate

The base interest rate has an important influence over the interest rates set throughout the economy by banks and other lending institutions. The base rate is the interest rate charged by the central bank to the commercial banking sector. The financial system in the economy is set up so that commercial banks need to continuously borrow money from the central bank. If the central banks change the base rate the commercial banks will pay a different rate and they will then pass on this change in interest rate to their customers and the interest rate change will filter through the economy. For example, if the base rate is increased it means commercial banks have to pay more to the central bank, they will then pass the interest rate increase to their customers and interest rates throughout the economy (personal loans, mortgage and credit card interest rates) will increase.

Market interest rates

The other important influence on interest rates in the economy is the interest rates set in the money markets. The market rate of interest is determined by the demand and supply of money.

Demand for money

Firms and households demand money because they need to make transactions when they buy goods and services. There is a negative relationship between the rate of interest and the demand for money because as the rate of interest increases the quantity demanded of money falls as the cost of borrowing increases. This means firms and households borrow less and therefore demand less money to buy goods and services. This is particularly true of goods such as cars and goods associated with home improvements. As interest rates decrease the quantity demand for money increases as the cost of borrowing decreases. The demand for money is shown in diagram 3.38.

Supply of money

The supply of money in the economy is set by the central bank and the banking system. The central bank controls the money issued to the banking system and the banking system creates credit that determines the amount of money circulating in the economy. The supply of money is fixed in a given time period and is perfectly inelastic. This is shown in diagram 3.38.

Equilibrium interest rate

The equilibrium rate of interest rate is set where the demand for money equals the supply of money in diagram 3.38.

Changes in the market rate of interest

The market interest rate will change if there is either a change in the demand for money or the supply of money. For example, if there is a fall in aggregate demand in a recession there will be fewer transactions and the money demand curve will fall from Md to Md1 causing a fall in the market of interest. This is shown in diagram 3.39.

Nominal and real interest rates

Nominal interest rates make no allowance for inflation. Most of the economic data used to report the state of the economy use interest rates stated in nominal terms. If a central bank increases interest rates from 1 per cent to 2 per cent this will lead to an increase in the nominal interest rate. The real interest rate makes an allowance for inflation. It is calculated as:

Nominal interest rate – inflation rate = real interest rate

If a country has a nominal interest rate of 5 per cent and the inflation rate is 2 per cent, the real interest rate is:

5% - 2% = 3%

The real interest rate is used by firms and households to give them information about the returns they pay or receive on money borrowed or saved. For example, if an individual saves money at a nominal interest rate of 4 per cent and inflation is 5 per cent they know the real value of their savings will be falling.

Contractionary monetary policy

Governments and central banks apply contractionary monetary policy when they increase interest rates and reduce the supply of money to reduce the rate of inflation.

How the policy works

If inflation rises in the economy the central bank raises its base rate which is the interest rate it charges to commercial banks. The commercial banks then pass on the higher interest rate to their customers and this raises interest rates throughout the economy. Households and firms start paying higher interest costs on loans and receiving greater interest returns on money held in banks.

As the interest rates rise throughout the economy consumption and investment fall and this reduces aggregate demand.  As aggregate demand falls in an economy the average price level falls fromacro economyd inflation falls. In diagram 3.42 the fall in aggregate demand closes the inflationary gap as output falls from Y to YFE.

The flow diagram illustrates the monetary transmission mechanism of contractionary monetary policy.

Evaluation of contractionary monetary policy

• Contractionary monetary policy can be applied quickly which gives it flexibility as a policy. If the rate of inflation rises the central bank can react almost immediately to increase interest rates to reduce aggregate demand and inflation.
• Contractionary monetary policy can be applied incrementally so it can be adjusted to changes in the inflation rate. If the inflation rate is rising month by month, interest rates can be continuously increased to tackle the problem.
• Because central banks are independent of governments in most countries they have some freedom to apply contractionary monetary without political influence. For example, a rise in inflation might need a rise in interest rates but the government might not want to do this for political reasons, but an independent central bank can still increase the rate of interest to reduce inflation.  

Weaknesses

• When a contractionary monetary policy is being applied the fall in aggregate demand may lead to a reduction in economic growth and even a recession and this will lead to a rise in unemployment. This is shown in diagram 3.42 when aggregate demand falls from AD to AD1 because of a rise in interest rates.
• An increase in interest rates by the central bank in its application of contractionary monetary policy may not be passed on by the commercial banks. The lending market is competitive and if banks are competing to make loans to new customers, they might not pass on the increase in interest rates so they can keep attracting new borrowers with lower interest rates.  
• Similar to expansionary monetary policy, there are time lags in the application of the policy that makes it difficult to manage.  The estimated 18 months it takes for the full effects of an increase in interest rate to have an impact on the macroeconomy leads to policy mistakes.  If the government increases interest too much this can lead to a fall in economic growth and even a recession.
• An increase in interest rates as part of contractionary monetary policy can lead to an appreciation in the exchange rate as foreign currency investors are attracted to the domestic currency by higher interest rates in domestic banks. As the exchange rate appreciates it makes export prices more expensive and import prices cheaper and this can lead to a balance of payments current account deficit.