2.6.2 Monetary Policy Instruments

This study note for Edexcel economics covers Monetary Policy Instruments

Overview

Monetary policy involves the actions taken by a country's central bank to influence the availability and cost of money and credit to achieve macroeconomic objectives such as controlling inflation, maintaining employment, and achieving economic growth. Key instruments of monetary policy include interest rates, asset purchases (quantitative easing), and intervention in currency markets.

Interest Rates

Definition:

• The interest rate is the cost of borrowing money or the return on savings, set by the central bank to influence economic activity.

Mechanism:

• Lowering Interest Rates: Encourages borrowing and spending by consumers and businesses, stimulating economic growth.
• Raising Interest Rates: Discourages borrowing and spending, aiming to cool down an overheated economy and control inflation.

Example:

• U.S. Federal Reserve (2008-2015): The Fed reduced the federal funds rate to near zero during the Global Financial Crisis to stimulate the economy.

Effectiveness:

• Short-term Impact: Immediate influence on borrowing costs and economic activity.
• Long-term Impact: Influences expectations about future inflation and economic conditions.

Asset Purchases to Increase the Money Supply (Quantitative Easing)

Definition:

• Quantitative easing (QE) is a non-traditional monetary policy tool where the central bank buys financial assets to inject liquidity into the economy.

Mechanism:

• Purchasing Assets: Central banks buy government bonds and other financial assets, increasing the money supply and lowering interest rates on these assets.
• Encouraging Investment: Lower yields on bonds push investors towards riskier assets like stocks, stimulating economic activity.

Example:

• Bank of England (2009-2012): Implemented QE by purchasing £375 billion of assets to support the UK economy during the financial crisis.

Effectiveness:

• Liquidity Injection: Increases bank reserves, encouraging lending.
• Market Confidence: Signals the central bank's commitment to supporting the economy.

Intervention in Currency Markets

Definition:

• Currency market intervention involves the buying or selling of a country’s currency by its central bank to influence the exchange rate.

Mechanism:

• Buying Domestic Currency: Reduces money supply, increasing its value.
• Selling Domestic Currency: Increases money supply, decreasing its value.

Example:

• Swiss National Bank (2011-2015): Intervened to cap the Swiss franc against the euro to protect exports.

Effectiveness:

• Exchange Rate Stability: Helps stabilize the currency, supporting trade and investment.
• Competitive Exports: A weaker domestic currency makes exports cheaper and more competitive globally.

Glossary

• Asset Purchases: The buying of financial assets by a central bank to increase the money supply.
• Currency Market Intervention: Actions by a central bank to influence the value of its currency.
• Exchange Rate: The value of one currency for the purpose of conversion to another.
• Interest Rate: The cost of borrowing money or the return on savings.
• Quantitative Easing (QE): A non-traditional monetary policy tool involving large-scale purchases of financial assets to inject liquidity into the economy.

Key Economists

John Maynard Keynes:

• Advocated for active government and central bank intervention to manage economic cycles.
• Emphasized the role of monetary policy in influencing aggregate demand.

Milton Friedman:

• Monetarist who highlighted the importance of controlling the money supply to manage inflation.
• Criticized extensive fiscal intervention, favoring monetary policy.

Christina Romer:

• An economic historian who has extensively studied monetary policy responses during economic downturns.
• Advocated for aggressive monetary intervention during the Global Financial Crisis.

Janet Yellen:

• Former Chair of the Federal Reserve, emphasized the importance of monetary policy in achieving low unemployment and stable inflation.
• Advocated for continued monetary support during economic recoveries.

Anna Schwartz:

• Collaborated with Milton Friedman on the seminal work "A Monetary History of the United States."
• Highlighted the importance of monetary policy in the Great Depression.

Different Economic Perspectives

Classical Economists:

• Favor minimal intervention, believing that markets are self-correcting.
• Skeptical of the long-term benefits of active monetary policy.

Keynesian Economists:

• Support active monetary policy to manage economic cycles.
• Advocate for lower interest rates and QE during recessions.

Monetarist Economists:

• Emphasize the control of money supply to manage inflation.
• Caution against over-reliance on interest rate manipulation and QE.

Austrian Economists:

• Criticize monetary interventions, arguing they create distortions and long-term economic imbalances.
• Advocate for a return to sound money principles, such as the gold standard.

Possible Essay-Style Questions

1. Discuss the effectiveness of interest rate adjustments as a tool for managing economic activity, using examples from recent history.
2. Evaluate the impact of quantitative easing on financial markets and economic recovery during the Global Financial Crisis.
3. Analyze the role of central bank intervention in currency markets and its effects on trade and economic stability.
4. Compare and contrast the approaches of different economic schools of thought regarding the use of monetary policy instruments.