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2.5 Monetary Policy

Monetary policy

The Central Banks

What is a central bank?

A central bank is the premier financial institution in a country. It conduct monetary policy (raising and lowering of interest rates, lends money to the government, regulates commercial banks and mantains order and liquidity in the financial markets. 

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What are it's three aims?

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  1. Banker to the government: It works much like a commerical bank, but against the government instead. It houses the government's money, takes care of its payments and deposits, and loans the government money when it needs it. 

  2. Regulates commercial banks. The central bank also loans money to the commercial banks within the government, and works as a regulator. It is supposed to maintain them and make sure that they follow the country's financial laws and regulations, such as having a certain amount of capital at hand at all times, or not mixing commerical and investment banking (if the country has such regulation). A shining example of when the central bank failed to do this is the FED (America's central bank) leading up the the 2008 crash, with its failure to enforce and regulate the investment banks.

  3. Conduct monterary policy. The absolute major role of a central bank is to conduct monetary policy - that is, to determine the interest rates in the economy. More about that further below.

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Interest Rates Explained

Why is it important that the central bank is independent?

When the central bank is independent, it is free from any political restraints and can operate long-term. It answers to the government, but is not controlled by it. Regardless of who's in office or their short-term political objectives, the central bank can focus on long-term stability.

The Role of Monetary Policy

Monetary policy and short-term demand management

A change in interest rates is the single greatest tool the Central Bank has to control agreggate demand in the short term. It can do this by either lowering interest rates, to speed up the economy, or increase rates, to slow it down.​

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Decreased interest rates to boost aggregate demand

Interest rates in an economy essentially control how much money is in circulation in the economy and can be spent. When the central bank wants to increase aggregate demand, it decreases interest rates. This is also known as expansionary monetary policy, since the government wants to expand aggregate demand. This will increase the money supply in two ways. Firstly, it makes the effective price of money cheaper: when interest rates are low, it is cheaper to borrow money. This will increase household borrowing to spend and corporate borrowing to invest, thus boosting aggregate demand. The second way in which it will affect the money supply is by discouraging saving. When interest rates are low, corporations and households aren't incentivized to save, since they make no money from it. Low interest rates thus encourages spending. Low interest rates = boost in aggregate demand. This is the mechanism used to close a deflationary (recessionary) gap. 

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Increase interest rates to lower aggregate demand

When the central bank however decides that the economy needs to slow down, it can do so by increasing interest rates. This is also known as contractionary monetary policy, since the government wants both a contraction of aggregate demand and of the money supply. This will have the exact opposite reaction. When interest rates are high, the price of borrowing money increases, discouraging household and corporte loans to spend. As well, high interest rates encourage money, since people effectively make money from saving it in the long-term. This will discourage spending, thus slowing down the economy by slowing down the flow of money in it. High interest rate = decreasing aggregate demand.

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Monetary policy and inflation-targeting

Many central banks in the developed world, have a singular focus, and have begun to focus on inflation-targeting. This is when they attempt to adjust their interest rate to aim a certaint target rate of inflation. Usually, this target rate is somewhere between 2-3%. It is considered to be a "good rate" - meaning that the economy is still growing, but not so fast that one needs to be concerned with overheating, and that it is not suffering so much disinflation that it is in the dangers of deflation. The central bank therefore focuses mainly and only on the inflation target, not working towards full unemployment at all. Inflation targeting also provides consistency for the economy over the long term and adds predictability to corporations, households and markets.

Monetary and Fiscal

Diagrams: Expansionary Monetary Policy

The expansion of monetary policy increases the aggregate demand within a country, shifting the AD curve to the right. Whether or not this will in turn increase the rate of inflation (and thus the price level) depends on the shape of the LRAS curve and where the original AD curve was to begin with. Below are two versions of both the models.

Diagram: Contractionary Monetary Policy

Contrationary monetary supply decreses aggregate demand, shifting it to the left. Again, whether this will affect the price level (and thus the rate of inflation) depends on the LRAS curve and where AD was to begin with. Below are two diagrams showcasing this.

How effective is Monetary Policy?

Dis-advantages

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  • Ineffectual in deep recessions. Sometimes, monetary policy just isn't enough. Interest rates can only go so low - at zero (or on very rare occasions, negative). When this still fails to help, monetary policy is useless.

  • Stagflation. Monetary policy can do very little to combat stagflation.

  • Conflicts with other government policies. For example, with government policies aimed to decrease unemployment. 

Advantages

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  • Provides long-term stable inflation rate. This is one of it's real selling-points. Monetary policy, and specifically inflation-targeting, allows the country long-term stability in terms of inflation rates. This helps businesses and consumers, as well as for the government, who can plan ahead with a stable rate of inflation.

  • Very quick to enact. Monetary policy can essentially be enacted overnight, from one day to another, whilst supply-side policies take years and years.

  • Political freedom. Monetary policy, as opposed to fiscal policy (more on that below) won't change over the long term since it is enacted by an independent organization.

  • No crowding out. More on this when you read the supply-side policies further down.

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2.6 Supply-Side Policies

Supply side policies

What are supply-side policies?

Supply-side policies aim to increase an economy's production

Supply-side policies are those that aim to move the LRAS outwards; to increase it. These are policies that effectively want to increase how much the country can produce - increase both the quality and quantity of goods produced. Increasing government spending is known as expansionary fiscal policy, while cutting government spending to slow down the economy is known as contractionary fiscal policy. Ever heard of a stimulus packet? That's government spending intended to grow the economy - to stimulate it towards growth.

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Two types of supply-side policies

There are two types of supply-side policies; one aimed at stimulating the market, and another that is classified as "interventionist" because of the governments spending. In both cases, the end goal is the same: to increase production. 

Interventionist supply-side policies

  • Investments in Human Capital
    One of the most common and important supply-side policies is the investment in human capital. This is done by government spending in educaiton and training: building schools, universities and adult re-training facilities that are subsidized by the state. The smarter people in the country is, the more human capital the country has. In short term, this will increase aggregate demand, as more money is pumped into the economy in the form of jobs for teachers and construction for the new schools. But in the long term, this will increase both the quality and quantity of goods and services, and increase the country's aggregate supply curve: it will increase LRAS.
     

  • Investments in new techology

    Government policies that encourage research and development, such as patents and subsidizing of scientific centers, will encourage innovation. This in turn may lead to advances in the country's level of technology, something that will allow the country to produce a higher quantity of and higher quality of goods and services. Short term , it will increase aggregate demand, long term, it will shift LRAS to the right. 
     

  • Investments in infrastructure

    Government expenditures to improve infrastructure will long-term shift the LRAS curve to the right. The easier it is for people to move around in an economy, the better corporations can move goods and services from place to place. In theshort term, better infrastructure will also increase aggregate demand.
     

  • Industrial policies

    The government can also target specific industries by allowing them reductinos in taxes, or subsidizing their production. This will encourage and expand industries that the government deem fit, in areas that will lead to long-term growth of the economy and shift the LRAS curve. This may include subsidizing the industry of solar power, which in the long term could lead to the shift of LRAS curve. In short term, it will naturally have an impact on aggregate demand. 

Fiscal policy: a debate

Market-based supply-side policies

  • Policies to encourage competition
    The government can implement a number of legal aspects to encourage competition in the economy. This may include deregulation to allow for increase competition, or the privatization of previously government owned corporations to induce more competition. They may also liberalize trade, to allow for increase exports and imports, to allow for foreign competition. Additionally, most countries enact some form of antimonopoly regulation, to break up large monopolies or to prevent the mergers of large corporations to stop oligopolies. The more competition in the economy, the better the products, and the lower the prices. This increases LRAS.
     

  • Labour Market reforms
    Another way the government can affect growth is to reform the labour markets, such as reducing the power of labour unions and reducing unemployment benefits. The aim of this is to make the labour market more flexible - more responsive to supply and demand - and therefore lead to more hires. If corporations know that they can fire someone if they need to, they may be more inclined to hire. Additionally, if there are no minimum wages, more people may be hired. All of this will increase the LRAS by reducing unemployment. Still controversial policies though.
     

  • Incentive related policies
    The government can also cut personal income taxes to increase the incentive to work; the harder you work, the more you will receive (as less is now taken by taxes). Something similar can be down to increase the incentive to invest, in terms of cutting business and capital gains tax. This makes it more lucrative and profitable to run businesses or to invest in them. It increases the incentive to entrepreneur, and thus, increases LRAS.

How effective are supply-side policies?

Advantages

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  • Decreasing unemployment. Because many supply-side policies tend to increase production, they also increase job opportunities and create employment in the economy. This will decrease unemployment, which is good for the entire economy - the more people employed, the more money is being earned, the more taxes the government received, and the better for social welfare.

  • Reduce inflationary pressure. When the LRAS shifts to the right, it drives down inflation. This is because their are more goods and services in the economy now, so the price level should go down. The less scarce things are, the lower their price is. Therefore, supply-side policies are a good solution to high levels of inflation. 

  • Increase economic growth. Because supply-side policies aim to increase the LRAS, and often strive for very long-term growth, it is a good way to increase a country's GDP. 

  • Increase equality. Interventionist supply-side policies that are aimed at increasing education or infrastructure also, inevitable, help the distribution of wealth in the economy and reduce inequaltiies because they allow even the poorest access to the means for success. 

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Dis-advantages

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  • Time lags. Supply-side policies often take a minimum of a year to feel effect, or far far longer. For education reforms and investments, that might take up to 20 years to finally increase the production in the economy. 

  • Government budget. Supply-side policies, particularily those that are interventinoist, tend to be expensive. They will therefore be a lag on the governments budget.

  • Decreased equality. Market-based supply-side policies tend to worsen equality, because of the effect they have on the labour market and unemployment benefits. Incentive-related policies, especially tax cuts, also tend to make equality worse. 

  • Environemntal degradation. Market-based supply-side policies, such as deregulation, may have a negative response to the environment, especially if the things deregulated is legislation regarding pollution.

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