24/7/2012

ECN200

MONETARY POLICY

1220803 | Jenifar Soheli

ECN 200: Assignment Monetary Policy

Question: Discuss the effectiveness of monetary policy in controlling inflation and recession of an economy. Monetary Policy: Monetary policy includes governments attempt to manipulate money supply, the supply of credit, interest rates or any other monetary variables to achieve the fulfillment of policy goals such as price stability. Government has four key objectives, to control inflation, reduce unemployment rate, to maintain current account equilibrium and to secure high economic growth i.e. prevent recession. Monetary policy consists of deliberate changes in money supply by bringing changes in interest rates, reserve ratio, monetary base etc. depending on the goal in hand. Monetary policy can be used by the government to combat inflation as well as recession but its effectiveness will depend on several factors circulating the situation as discussed below: Inflation: Inflation is the economic situation where average price level increases persistently. An Economy can face inflation due to either Rise in Money supply or Rise in Factor cost. The government as mentioned earlier can use interest rate, reserve ratio, discount window etc. as its tools to control inflation. Rate of interest to control inflation: In case of the demand pull inflation a rise in money supply increases demand and causes price level to rise. Thus to combat this situation government aims at reducing money supply and its velocity of circulation which will increase the rate of interest (figure a). It can be done so by using contractionary monetary policy. A contractionary monetary policy is first taken through rate of interest. An increase in rate of interest would increase the opportunity cost of saving as well as make borrowing expensive for both firms and households. As a result consumption is discouraged. Thus consumption (C) falls.

Figure 1 Contractionary Policy: Decrease in Money Supply to control Inflation

This would reduce the AD1 to AD2 and price level would go down. At the same time however cost of capital increases causing an adverse effect on investment (figure b). A fall in investment can result in more unemployment and therefore less income & consumption and again a fall in AD. So, the AD curve shifts to left from AD1 to AD2, lowering the price level and inflation (figure c). Jenifar Soheli | ID # 1220803 2|P a ge

ECN 200: Assignment Monetary Policy

However, a fall in government spending (say on education and health care) may reduce the productivity of work force in the long run and thus a fall in aggregate supply curve (AS). This in the long run shall create inflationary pressure. A reverse policy is used for controlling cost push inflation which occurs due to rise in factor cost. Printing Money: Inflation is controlled by printing money. Printing money increases the money supply, decreasing the rate of interest. It will increase the investment, so as the national income. So, price level decreases so as inflation. P= M X V Q [M= Printing Money V= Velocity P= Price Level Q=Quantity] Open Market Operation: It deals with bond selling and bond buying. It is not wise to print money because when money supply increases consumer confidence decreases. Adverse effect on the economy takes place, because this decreases the consumption and savings as well. To increase money supply, the central bank will buy bonds. So, people will get back money, and money supply increases. M= X R [M = Change in money supply Z= Reserve Ratio R =Change in reserve] Reserve Ratio: This is the portion (expressed as a percent) of depositors' balances banks must have on hand as cash. This is a requirement determined by the country's central bank. The reserve ratio affects the money supply in a country. In order to reduce money supply the central bank can increase the reserve ratio which shall reduce loanable fund and ultimately money supply. Discount Rate: Discount rate is the rate at which commercial bank takes loan from the central bank. They can usually take 5 times of the reserve they keep in the Central Bank. The loan is taken at a lower rate against the reserve fund, so the commercial bank will charge lower rate of interest on loan for its customers. So people will take more loans from the commercial bank. So, money supply increases and thus controls inflation. Conclusion on Effectiveness However the governments attempt at reducing money supply to control inflation using increased interest rate, reserve ratio or carrying out open market operation serves as only short term solution. In order to achieve perpetual price stability supply of goods must be increased permanently which alone monetary policy cannot do- in fact contractionary monetary policy adversely affects investment and economic activities. Thus government will need to opt for supply side policies in to have better control over inflation.

Jenifar Soheli | ID # 1220803

3|P a ge

ECN 200: Assignment Monetary Policy

Recession: During an economic recession, unemployment rises while incomes, business investment and consumer spending fall. Monetary policy aims to shorten recessions by encouraging consumer spending and investment. Monetary policy actions can help shorten recessions or reduce their impacts, but economic conditions may limit their impact. In addition, it takes time for policy decisions to be felt throughout the economy at large. Monetary policy controls a recession setting how much money is supplied in an economy. When an economy is in a recession the central bank will typically increase the money supplied which will help reduce interest rates; increasing spending. Monetary Policy in controlling recession: Government usually responds to an economic recession through stimulative fiscal policy, expansionary monetary policy or a combination of the two. Expansionary monetary policy consists of actions by central banks, such as the U.S. Federal Reserve, to expand the money supply to encourage more consumer spending and business lending.

Figure 2 Expansionary Policy: Increase in Money Supply to control Recession

Expansionary monetary policy aims to increase aggregate demand and economic growth in the economy. This involves in the cutting interest rates or increasing the money supply to boost economic activity (figure a). Expansionary monetary policy could also be termed a loosening of monetary policy. When interest rate decreases people invest more, so investment increases (figure b). By decreasing such rates, strength to sustain economic growth is foreseeable. This causes AD to increases AD1 to AD2. This results in the increase in real GDP and price level, and thus recession is controlled (figure c). Effects: The purchase of government bonds by central banks injects more money into the economy. Lower reserve requirements give banks more money to lend because they are required to hold fewer reserves against deposits. Increased lending by banks stimulates business investment and expansion. A reduction in short-term interest rates also encourages more investment by reducing the cost of borrowing. Lowering short-term interest rates also reduces the rates on home mortgages, lowering mortgage payments for homeowners, giving them additional disposable income.

Jenifar Soheli | ID # 1220803

4|P a ge

ECN 200: Assignment Monetary Policy

Considerations: Although expansionary monetary policy has the ability to reduce the length and severity of an economic recession, there is no guarantee it can do so. Lower interest rates, for example, may not stimulate consumer spending if consumers have little confidence in the economy. They are unlikely to increase their spending if they believe their jobs are at risk because of a sluggish economy. Businesses may be reluctant to invest in new facilities and equipment for expanded operations if the economy is in a recession. Finally, banks may be unwilling to increase their lending during a recession. Evaluation: Elasticity of the AS curve: The effectiveness of the monetary policy will depend on the elasticity of the AS curve, i.e. where the economy is operating. If the economy is operating near the full employment level, then contractionary policy will be very effective. If the economy is operating in the horizontal part of the AS curve, expansionary policy will be more effective. Below the full employment level, i.e. horizontal part, if AD increases (AD1 to AD2), then GDP is increased much (GDP1 to GDP2), but price increase is less. Near to the full employment level, i.e. slanting part of AS curve, if AD increases (AD3 to AD4) then GDP increase is less (GDP3 to GDP4) but price increase is much. Operating in the full employment level, i.e. vertical, no growth is possible. A tight monetary policy can reduce inflation with little effect on unemployment if economy is near or above full-employment (AD6 to AD5) A tight monetary policy can make unemployment worse in a recession. (AD2 to AD1)
Figure 3 Elasticity of AS curve

Effectiveness of Monetary Policy: Monetary policy is very effective because it is speedier and more flexible than fiscal policy since the Fed can buy and sell securities daily. It is also less political. Fed Board members are isolated from political pressure and policy changes are more subtle and not noticed as much as fiscal policy changes. It is easier to make good, but unpopular decisions. Though monetary policy is effective, but sometimes it creates problems and complications. Recognition and operational lags impair the Fed's ability to quickly recognize the need for policy change and to affect that change in a timely fashion. Cyclic asymmetry may exist: a tight monetary policy works effectively to break inflation, but an easy monetary policy is not always as effective in stimulating the economy from recession. The velocity of money (number of times the average dollar is spent in a year) may be unpredictable, especially in the short run and can offset the desired impact of changes in money supply. Tight money policy may cause people to spend faster; velocity rises. The impact on investment may be less than traditionally thought. Japan provides a case example. Despite interest rates of zero, investment spending remained low during the recession. 5|P a ge

Jenifar Soheli | ID # 1220803