Monetary Policy

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Monetary Policy
Week 9 (final lecture of MT) Professor Dermot
McAleese
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OUTLINE
? What is monetary policy? ? How does it affect
economy? ? Effectiveness of Monetary policy ?
Issues in Monetary policy
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MONETARY POLICY

• ? Primary target
• ? Intermediate targets
• ? Instruments

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• 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

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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 - ?
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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
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INTEREST RATES AND ECONOMIC ACTIVITY

• ? Substitution effect
• ? Income effect
• ? Wealth effect
• ? Investment effect

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

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ISSUES in MONETARY POLICY

• ? Active vs. passive
• ? Rules vs. discretion
• ? CB as a supervisor
• ? Transparency vs. secrecy

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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, 1996 2. 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?