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Monetary Policy

Monetary Policy. Week 9 (final lecture of MT) Professor Dermot McAleese. OUTLINE.  What is monetary policy?  How does it affect economy?  Effectiveness of Monetary policy  Issues in Monetary policy. MONETARY POLICY.  Primary target  Intermediate targets  Instruments.

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Monetary Policy

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  1. Monetary Policy Week 9 (final lecture of MT) Professor Dermot McAleese

  2. OUTLINE  What is monetary policy?  How does it affect economy?  Effectiveness of Monetary policy  Issues in Monetary policy

  3. MONETARY POLICY Primary target  Intermediate targets  Instruments

  4. Primary target PRICE STABILITY Intermediate targets Money supply Interest rates Exchange rate Instruments Direct: Interest regulations Credit controls Market based: Discount rate Reserve ratio Open market operations

  5. INTEREST RATE The interest rate is the amount of interest paid per unit of time as a fraction of the balance outstanding. Fisher relation REAL interest rate = NOMINAL interest rate minus inflation r = i - 

  6. WHAT DETERMINES INTEREST RATES? r S D1 D r1 r D1 D A A1 I, S S r S1 E E1 D S S1 I, S

  7. INTEREST RATES AND ECONOMIC ACTIVITY Substitution effect Income effect Wealth effect Investment effect

  8. MONETARY POLICY AND AGGREGATE DEMAND • Substitution effect • (-) r  (-) S •  (+) C • Cash flow (income) effect • (-) r  (+) cash flow of borrowers • (-) r  (-) cash flow of lenders • Wealth effect • (-) r  (+) in asset values • (-) r  (+) C •  (+) I

  9. MONETARY POLICY AND AGGREGATE DEMAND (Cont.) • CB credibility effect • (-) r  (+) domestic confidence in CB • (-) r  (-) domestic price and wage increases • Exchange rate effect • (-) r  depreciation of real exchange rate  (+) X, (-) M

  10. Expansionary monetary policy Higher money base Lower interest rate Growing private sector credit Asset price inflation More spending More output in short run Consumer price increase Capacity constraint/ tight labour market Inflation

  11. MONETARY POLICY CAN SOMETIMES FAIL • Problem 1: Keynes’ liquidity trap where nominal interest rates fall to such a low level that no further cuts are expected (LM curve flat) • Problem 2: IS curve very steep, so outward shift of LM affects interest rate but not output • Problem 3: If prices are falling, the real interest interest rate rises, investment is deterred. Since nominal interest rates cannot fall below zero, central bank powerless. The Japan case.

  12. ISSUES in MONETARY POLICY Active vs. passive  Rules vs. discretion  CB as a supervisor  Transparency vs. secrecy

  13. Conclusions: 1. Conservative view: “How much do we really know about monetary policy?Enough to prevent it doing harm, but not enough to use it to do good.”David Laidler, Taking Money Seriously, 19962. Monetary policy an art not a science. Secret lies in responding in timely way (compare Japan and US)3. So far counter-cyclical policies have prevented major and prolonged depression. Will this continue?

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