MacroeconomicsI_working_version (1)

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Monetary Policy in Details 117 13. Monetary Policy in Details Contents: 13. MONETARY POLICY IN DETAILS.......................................................................... 117 13.1. TOOLS OF MONETARY POLICY ................................................................................... 118 13.2. THE IMPACT OF MONETARY POLICY ON OUTPUT AND PRICES ................................... 119 13.2.1. Transmission Mechanism: How Money Supply Affects Total Output................ 119 13.2.2. The Money Market ............................................................................................. 120 13.2.3. Supply and Demand for Money.......................................................................... 120 13.3. MONETARY POLICY IN THE AS-AD FRAMEWORK...................................................... 122 13.3.1. Monetary Effects in the Long Run...................................................................... 123
118 Chapter 13 Central banks have an important role in modern and highly developed countries. The main function of the central bank is to control money supply and credit conditions in the country. The central bank conducts national monetary policy, which should assist the economy in achieving the potential output (its non-inflationary level) and full employment. In addition to that fundamental objective, the central bank focuses on stabilising the price level in the country. The central bank may increase money supply in the economy to stimulate spending and investment during contraction of output. Conversely, it conducts restrictive monetary policy to slow down inflation and rapid rise in spending. Thus, a central bank may influence total output, employment and inflation by altering the supply of money in the economy. In fact, the central bank controls money supply by controlling the excess reserves held by commercial banks. These reserves play the key role in the money-creation process of the banking system in the economy 1 . In this chapter we will explain how altering money supply influences the nation’s interest rates, aggregate demand, total output and employment. 13.1. Tools of Monetary Policy Figure 13.1 describes the relationship among the monetary policy instruments, intermediate targets and ultimate objectives. There is a number of policy tools (instruments) the central bank can use to influence the intermediate targets such as interest rates, reserves, and the money supply). Controlling intermediate targets is, in fact, the way to achieve the ultimate objectives (Stable prices, low unemployment and sustainable growth in real output) in the economy. • Open-market operations consist of dealing with government bonds by the central bank in the open market. The central bank is buying bonds from, or selling bonds to, commercial banks and the general public. The aim of such dealing in the open market is raising or lowering commercial banks’ reserves. The open market operations are considered to have the most stabilising effect in the variety of central bank’s policy instruments. • Reserve-requirements policy (the reserve ratio) influences the bank-system’s ability to create new money by lending. This policy covers altering the legal reserve ratio requirements on deposits in banks and other financial institutions due to controlling money supply as an ultimate objective. Lowering the reserve ratio leads required reserves to excess reserves and enhances the ability to create new money by lending within the bank system. Raising the reserve ratio increases the amount of required reserves bank must keep and thus banks lose excess reserves. This reduces the ability to create new money by lending and hence supply of money decreases in the economy. • Discount-rate policy allows the member banks borrow reserves from the central bank at the discount rate (set by the central bank). The central bank, as “a lender of last resort” provides funds to commercial banks, which reveal unexpected and immediate needs for additional financing. This is the case, when the central bank provides shortterm loans. The interest rate called the discount rate is the charge for the commercial 1 To examine money-creation process see chapter 7.
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Page 131 and 132: The Phillips Curve 99 ∆P/P ∆W/W
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