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You are expected to define (AO1) monetary policy (SL/HL), explain/analyze (AO2) its goals (SL/HL), and explain/analyze (AO2) its tools (HL)
Definition (AO1)
Definition (AO1)
Monetary policy refers to the government’s use of interest rates and the money supply to influence the level of aggregate demand and economic activity. This is usually done by the country's central bank.
Goals of Monetary Policy (AO2)
Goals of Monetary Policy (AO2)
Low and stable rate of inflation - Central banks often have an inflation target, and will raise interest rates to get down to this level. The target is 2% for most developed countries (developing countries usually have it a bit higher)
Low unemployment
Reduce business cycle fluctuations
Promote a stable economic environment
External Balance (exports = imports)
The rest of this page is for Higher Level students only.
Tools of Monetary Policy (HL) (AO2)
Tools of Monetary Policy (HL) (AO2)
- Open Market Operations (OMOs)
The buying and selling of government bonds by the central bank.
If the central bank sells bonds, it gets money while the buyer gets a bond. The central bank can lock this money up. This reduces the money supply in the economy, increasing interest rates and reducing inflation.
If the central bank buys bonds, it gets bonds while the buyer gets money. This increases the money supply in the economy, decreasing interest rates and encouraging economic growth.
Sell bonds -> Contractionary policy
Buy bonds -> Expansionary policy
2. Minimum Reserve Requirements
2. Minimum Reserve Requirements
Banks want to lend out as much money as possible, as they make more off of interest.
The more money is lent out, the more money is invested and consumed.
If the central bank sets a minimum reserve requirement, banks are obliged to keep a certain amount of customer deposits safe (not lending them out). This decreases the amount of money lent out, indirectly decreasing investment and consumption.
3. Changes in the central bank minimum lending rate (base rate)
3. Changes in the central bank minimum lending rate (base rate)
Central banks of countries sometimes lend money out to commercial banks when they need it. If they increase this interest rate, commercial banks have a higher cost of borrowing money.
Commercial banks will offset this by raising their interest rates, making borrowing more expensive for households and firms.
This decreases consumption and investment.
4. Quantitative Easing
4. Quantitative Easing
Sometimes the central bank base interest rate is so low it can't go lower. So what do they do when the economy is in need of expansion?
Quantitative Easing refers to the buying and selling of bonds, but on a larger scale (and more long-term) than OMOs.
It is the same principle as OMOs, but the purchases are larger, and typically involve riskier bonds (corporate bonds instead of government bonds for example)
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