Professional Documents
Culture Documents
Me Group
Me Group
Although the expansionary monetary policy is useful during the slow period in a
business cycle, it comes with several risks. Such as the economist must know
when the money supply should be expanded so as to avoid its side effects
like inflation. There is often a time lag between the time the policy is made and
the time it is implemented across the economy, so up-to-the-minute analysis of
the policy is quite difficult or impossible. Also, the central bank and legislators
must know when to stop the supply of money in the economy and apply
a Contractionary Policy.
Thus, these are the monetary policies applied by the monetary authority to
control the inflationary or recessionary pressures in the economy.
1. Deflation
Deflation makes monetary policy much less effective. In fact deflation can
cause a liquidity trap which implies a cut in rates will have no effect on
boosting demand.
1. Firstly, deflation can increase the real interest rate. Suppose we have
deflation of -2%. Interest rates cannot fall below 0%. Therefore, the real interest
rate is effectively 2%. This will discourage borrowing and investment. (At the
moment, we have negative real interest rates because inflation is higher than
base rates; in theory this should encourage people to spend and invest. A fall in
prices has the effect of making monetary policy tighter.)
3. Deflation also increases the real value of debt. Firms and consumers spend a
higher % of their income on paying off debts leading to lower growth.
Solutions to Deflation
Deflation can be very damaging for attempts to avoid a recession. Monetary
policy can play a role in avoiding deflation and recession.
Zero interest rates . Firstly Central Banks can reduce base interest rates to zero.
Lower interest rates reduce cost of borrowing. However, with deflation, zero
interest rates will not be enough to avoid a fall in economic growth
Quantitative Easing . The Central Bank can electronically create money and use
this to buy bonds (both government and other financial bonds). This helps to
1. Increase the money supply. Bank reserves should rise; in theory this should
encourage them to lend more
2. Lower interest rates on long term bonds. By purchasing bonds, the Central
Bank will reduce interest rates on bonds. These lower interest rates can help to
encourage lending and spending. E.g. in 2011, the US Fed unveiled ‘operation
twist’ this involved buying mortgage securities to reduce interest rates on
mortgage bonds. The hope was this would encourage mortgage lending
Inflation Target . The Central Banks can make it very clear they are targetting
positive inflation. They could even increase the inflation target from 2% to 3%.
Increasing inflation expectations help to avoid the pressure of deflation.
Inflation
Inflation is a period of rising prices. Most Central Banks target low inflation. If
inflation rises above this inflation target, there are several economic policies,
such as monetary policy to reduce the inflation rate.
Monetary policy – Higher interest rates . This increases the cost of borrowing
and discourages spending. This leads to lower economic growth and lower
inflation.
monetary policy is the most important tool for maintaining low inflation. In the
UK, monetary policy is set by the MPC of the Bank of England. They are given
an inflation target by the government. This inflation target is 2%+/-1, and the
MPC use interest rates to try and achieve this target.
The first step is for the MPC to try and predict future inflation. They look at
various economic statistics and try to decide whether the economy is
overheating. If inflation is forecast to increase above the target, the MPC are
likely to increase interest rates.
Increased interest rates will help reduce the growth of aggregate demand in the
economy. The slower growth will then lead to lower inflation. Higher interest
rates reduce consumer spending because:
Increased interest rates reduce the disposable income of those with mortgages.
Higher interest rates increased the value of the exchange rate leading to lower
exports and more imports.