How Does Monetary Policy Work Across the cycle and Why Does it Sometimes Fail?

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En provenance du cours de IE Business School

Understanding economic policymaking

613 notes

IE Business School

Understanding economic policymaking

613 notes

This is the first of the three courses part of the Globalization, Economic Growth and Stability Specialization. This course will employ a non-technical approach to analyze how governments use policy to influence a country's economy. Upon completing the course you should be able to discuss national debts and deficits, examine fiscal and monetary policy and their appropriateness to the situation of an economy, and anticipate the results of fiscal and monetary policies and structural reform on a country. These concepts will give you the tools to develop your own position in many current economic debates, such as fiscal stimulus vs. austerity, the merits of quantitative easing, the need for higher interest rates or the future growth path of many modern economies.

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Monetary Policy

Welcome to Module 4! This week we're tackling a fascinating issue, which is monetary policy, and I anticipate some very interesting debates. Monetary policy is the other main tool that governments can use to influence the economy. Monetary authorities work through the money supply and can use open market operations, their own lending rates and reserve or cash ratios to influence money markets and hence the real economy. Just as with fiscal policy, once the gap in the economy is identified, expansive monetary policy should be used in a recessionary gap and restrictive monetary policy in an inflationary gap. Monetary policy is superior to fiscal policy in many ways, but its greatest weakness is that it does not work nearly as well in recessionary gaps as in inflationary gaps. Keep up the good work!

How Does Monetary Policy Work Across the cycle and Why Does it Sometimes Fail?10:08

Strengths and Weaknesses of Monetary Policy5:45

Conclusion: Module Four0:55

Rencontrer les enseignants

Gayle Allard
Professor
Economics

[MUSIC]

Once the central bank moves the supply of

money curve, how does this affect the economy?

How does this movement in the supply of money get

all the way down to a different level of GDP?

Well this is the tricky question.

This is one we're going to be addressing now.

In this diagram here on the right, you can see the movement of the money supply

that we saw as we were talking about the different tools of central banks.

And you can see that step one is for the central bank

to increase this money supply in the particular case we're looking at.

So money supply goes from the blue line to the red

line through one of those three tools that we've just mentioned.

The second thing that happens, which we also

just saw, is that the interest rate responds.

Now sometimes the interest rate doesn't respond, so

we may have trouble right here at the beginning.

But let's assume it responds, okay?

The central bank increases the supply of money.

The equilibrium interest rate in these free financial markets falls.

Okay?

Response to the monetary policy, all right?

And then we move to the graph on the right.

When the interest rate falls, if you think it through, and

you think about the aggregate demand elements that we talked about

a couple of weeks ago, you realize that the one that's

going to respond the most to a lower interest rate is investment.

Right?

We have, when we look at aggregate demand, we have

consumption, investment, government spending, and x minus m, or net exports.

Remember we has c plus i, plus g, plus x minus m.

Well it's the i, private investment, that's going to

respond most strongly to this lower interest rate.

This is people buying houses, this is corporations building projects.

So if the interest rate goes down, on the right hand graph we

will see aggregate demand shifting out

to the right, because there's additional investment.

So, so far the chain of events is, change the money supply, change

the interest rate, change aggregate demand through this move in investment.

All right?

The next thing that will happen is that GDP will change.

So it's kind of a four step process from that change in

the money supply until we get out to the change in GDP.

So what does the central bank want to do with GDP?

Well, just like fiscal authorities should do, the central bank wants to bring the

economy toward potential GDP, because remember every

central bank is trying to control inflation.

Even if it has a single mandate, it's trying to control inflation.

Now we know that when the economy

goes into an inflationary gap, inflation will accelerate.

So what the Central Bank is going to want to do is

bring GDP growth back down to potential so that inflation will decline.

So, in a period where the economy is growing

very fast and we are in an inflationary gap,

in a period of inflationary gap or positive output

gap, the central bank will want to raise interest rates.

When it raises interest rates by decreasing the money

supply, the next step will be for investment to decline.

Then aggregate demand shifts inward to the left and GDP growth goes

down, or GDP goes down to potential and then inflation will fall.

Okay?

So again, the chain of events its starts

with the central bank changing the money supply,

in this case they would reduce the money

supply, this would cause interest rates to rise.

As a result investment would fall and therefore

GDP or GDP growth would decline down to potential.

We would call this chain of events a restrictive monetary policy.

Just like we talked about restrictive

fiscal policy, there's a restrictive monetary policy.

And its objective is to restrict activity in the

economy so that it goes toward potential, becomes more stable.

Okay?

Now the opposite situation would be for the

central bank to want to expand the economy.

And that would happen if the economy is in a

recessionary gap, that we identified a couple of weeks ago.

So GDP growth is too low in a recessionary

gap, and the central bank wants to bring it up.

How does it do that?

Well it goes through the same chain of events The

only thing it can do is influence the money supply.

So in this case, and it's the one illustrated on the graph, in this

case it would increase the supply of money through one of its three tools.

The result would be for the interest rate to fall.

The next step would be for investors to then invest

more, which would shift aggregate demand out to the right.

And the final result would be for GDP or GDP growth to

accelerate and for the economy to move out of the recessionary gap up to potential.

So you can see that with monetary policy we also have

a restrictive and an expansive just like we have with fiscal policy.

In restrictive policy they are reducing the supply of money so

they get that interest rate up and they bring down GDP.

With an expansive policy they're increasing the supply of money so

they get the interest rate down and expand GDP up to potential.

Now what's interesting for us to see is how central banks actually change this

interest rate in different economies, and whether they do what we expect them to do.

All right?

I've got some pictures here that you can see on the graph.

These come from the United Nations.

And what they are comparing here is the interest rate with GDP growth.

Now that's not exactly what we're talking about, but it does give us a clue to

whether monetary policy is being expansive or restrictive

in these countries at different moments in time.

Now, here's the, the,

the equality, or the relationship that they're looking for.

What they're saying, and this is a simple way to understand monetary policy.

What they're saying is, if the real growth rate of GDP is

the same as the real interest rate, which is that interest rate

in our graph minus inflation, okay, so we take the interest rate

in that free market, and we adjust it for the inflation rate.

So they're saying if the real growth rate of GDP without inflation is about equal to

the real interest rate, the interest rate without

inflation, then monetary policy isn't doing anything, it's neutral.

Okay?

If instead we find that the real growth rate of GDP is

below the real interest rate, then monetary policy is restrictive.

It's trying to reduce the growth in

the economy, trying to reduce an inflationary gap.

If, in the third case, the real growth rate of GDP is above

the real interest rate, then monetary policy's effect is expansive.

It's giving room for the economy to grow more and for GDP to move up to potential.

So, if we look at these pictures you can see, starting with Germany,

this is between 1991 and 2011 the red line is the real interest rate.

So that's the interest rate that the central bank was

targeting in that free financial market minus the inflation rate.

Okay?

And the other line is the growth rate of GDP.

Now, we don't know if there's inflationary or recessionary gaps here.

We can guess.

But I just want you notice the relationship

between the interest rate and the GDP growth rate.

And you can see in this early period up

to about 2005 the interest rate, the real interest

rate is higher than the real GDP growth rate,

which means that had a restrictive effect on the economy.

So the central bank was trying to slow

down the economy, trying to get inflation down.

Okay.

Then we see in the period after 2005 there's a little bit more variety.

So, we see right away that the interest rate is below the real GDP growth rate.

Which would mean it would have an expansion affect.

Then we see it above again, and then we see it below.

We can look at some other countries here.

So if we look at for example Japan, you

can see the chart for Japan where the real interest

rate is again in their early period above the

real GDP growth rate indicating that that policy was restrictive.

And then in the later period we see

sometimes where it's below the real GDP growth rate.

However, you can notice, you see this with both Japan and Germany.

When the economy is deep in recession, as it was in 2009,

you can't get your interest rate below a negative GDP growth rate.

So this is one of the limits of

monetary policy, you can't go into negative numbers, okay?

And then you can see, for example if we look at China,

okay, we see the chart for China and we can see again that

there are moments in fact the entire period, if you look at this chart

where the real interest rate is below the real GDP growth rate.

So monetary policy in this whole period is expansive for China.

So this is an interesting thing to try to compare to see how central banks

are acting in different economies, and sometimes

we wonder why they act a certain way.

We think maybe this economy such as China maybe didn't need such

low interest rates, and we have to look for an explanation for it.

[MUSIC]

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