Monetary policy, the demand side of economic policy, refers to the actions undertaken by a nation's central bank to control money supply and achieve macroeconomic goals that promote sustainable economic growth.
This presentation goes through the certain features and limitations that are associated with this economic process.
3. STARTER
A tall one story house is completely made of red wood.
What color could the stairs be?
It’s a one story house, there are no stairs!
4. MEANING
Monetary policy is the macroeconomic policy laid down by the central bank.
It involves management of money supply and interest rate and is the demand side
economic policy used by the government of a country to achieve macroeconomic objectives like
inflation, consumption, growth and liquidity.
5. TYPES
Just like fiscal policies, monetary policies can be used to either expand or contract economic activity.
There are two types of monetary policies
1. Expansionary/loose monetary policy
2. Contractionary/tight monetary policy
6. EXPANSIONARY/LOOSE MONETARY POLICY
Expansionary monetary policy is when a central bank uses its tools to stimulate the economy. That
increases the money supply, lowers interest rates, and increases aggregate demand.
This aims to boost economic activity by expanding the money supply.
It is done mainly by lowering interest rates.
It makes borrowing more attractive to households and firms because they are charged lower interest
repayments on their loans.
Those with existing ones have more disposable income and have available money to spend.
8. CONTRACTIONARY/TIGHT MONETARY POLICY
Contractionary monetary policy is a form of economic policy used to fight inflation which involves
decreasing the money supply in order to increase the cost of borrowing which in turn decreases GDP
and dampens inflation.
This process is almost opposite of expansionary monetary policy.
This is used to control the threat of inflation, although can cause job loss in the long run.
10. OBJECTIVES
(i) Neutrality of money
(ii) Stability of exchange rates
(iii) Price stability
(iv) Full Employment
(v) Economic Growth
(vi) Equilibrium in the Balance of Payments.
11. LIMITATIONS
Liquidity Trap – This occurs when a cut in interest rates fail to stimulate economic activity. e.g. because of
low confidence or banks don’t want to pass base rate cut onto consumers.
Difficult to control many objectives with one tool – interest rates. For example, a rise in oil prices causes
cost-push inflation and lower growth. The Bank could increase interest rates to reduce inflation, but, it
would cause economic growth to fall as well. In 2009, inflation rose to rising oil prices, but the economy
was also in recession; the Bank decided to ‘allow’ the temporary inflation and concentrate on economic
recovery.
Changing interest rates affects the exchange rate. Tight monetary policy causes an appreciation in the
exchange rate which will make exports less competitive.
Interest rates may affect some parts of the economy more than others. e.g. higher interest rates increase
the disposable income of people with savings. But, could cause homeowners to be unable to afford their
mortgages.
Time lags– If the Bank of England change base rates, it can take up to 18 months for the effects to filter
through the economy. For example, if people have a two-year fixed mortgage, they will not notice until
they remortgage. This means the Bank needs to predict future inflation so that they can change interest
rates in anticipation.
