3.5 Demand Management: Monetary Policy (DP IB Economics: HL): Flashcards

Expansionary (loose) monetary policy aims to shift aggregate demand to the right, using tools such as reducing interest rates, increasing QE or depreciating the exchange rate.

Contractionary (tight) monetary policy aims to shift aggregate demand to the left to slow growth or reduce inflation, using tools such as raising interest rates, reducing QE or appreciating the exchange rate.

Lower interest rates raise consumption and investment, which are components of aggregate demand, shifting AD to the right.

False.

Contractionary monetary policy shifts aggregate demand to the left, reducing real output and the average price level.

True.

Monetary policy can be adjusted 4-8 times a year, whereas fiscal policy is usually adjusted only once a year, though fiscal policy's impact is more predictable.

AD = C + I + G + (X − M), where C is consumption, I is investment, G is government spending and (X − M) is net exports.

Fractional reserve banking is the process of money creation by commercial banks, involving a cycle of lending and deposit creation in which banks hold only a fraction of deposits as reserves.

Banks hold reserves to meet the demands of customers who want a portion of their money back.

False.

Fractional reserve banking increases the money supply, as an initial deposit is effectively multiplied into multiple deposits through successive rounds of lending.

The four tools are open market operations, minimum reserve requirements, changes to the base rate and quantitative easing.

Open market operations are the buying and selling of government securities, such as bonds, by the Central Bank in the open market.

Buying back bonds injects money into the system and increases commercial bank reserves, making it easier to lend and potentially lowering interest rates.

When the Central Bank sells government bonds, it withdraws money from free circulation.

Minimum reserve requirements are regulations set by the Central Bank mandating the minimum percentage of customer deposits that commercial banks must hold as reserves.

A higher reserve ratio leaves banks with less money available to lend, so the money supply decreases.

The base rate (or official rate) is the interest rate at which the Central Bank lends money to commercial banks, used as the benchmark for interest rates generally.

A transmission mechanism is the ripple effect of a policy change through the economy, with an activator and several steps resulting in a particular outcome.

A lower base rate reduces market rates, making loans cheaper, so consumers borrow and spend more, raising consumption and aggregate demand.

Quantitative easing is a tool where the Central Bank creates new electronic reserves to purchase government bonds, used to stimulate the economy when traditional measures have become less effective.

QE is typically employed when interest rates are already near zero and traditional policy measures are insufficient to address economic challenges.

False.

In QE the Central Bank creates new electronic credits ('prints' new money), whereas traditional open market operations use existing reserves.

Central banks can operate independently of the political process and take a long-term view; policy can also be adjusted or reversed quickly (4-8 times a year).

Consumers may not respond to lower interest rates when confidence is low, and expansionary policy becomes less effective as rates approach zero.

Expansionary monetary policy is less effective during a deflationary gap.