IB DP Economics - Unit 3 - Tools of monetary policy-Study Notes - New Syllabus

Tools of Monetary Policy

Central banks use several tools to influence:

• Money supply
• Interest rates
• Bank lending
• Aggregate demand

These tools help the central bank achieve macroeconomic objectives such as:

• Low and stable inflation
• Low unemployment
• Stable economic growth
• Financial stability

The main tools of monetary policy are:

• Open market operations
• Minimum reserve requirements
• Changes in the central bank minimum lending rate
• Quantitative easing

1. Open Market Operations

Open market operations (OMO) refer to the buying and selling of government securities (bonds) by the central bank in financial markets.

OMO directly affects:

• Bank reserves
• Money supply
• Interest rates

Expansionary Open Market Operations

To increase money supply, the central bank buys government securities from commercial banks or the public.

How Buying Securities Increases Money Supply

When the central bank purchases bonds:

• Commercial banks receive additional reserves.
• Banks gain greater ability to lend.
• Money supply increases.

Central bank buys bonds → Bank reserves increase → Lending increases → Money supply increases

Effects of Expansionary OMO

• Interest rates tend to fall.
• Borrowing and investment increase.
• Aggregate demand increases.
• Economic growth and employment may rise.

Contractionary Open Market Operations

To reduce money supply, the central bank sells government securities.

How Selling Securities Reduces Money Supply

When banks and investors buy government securities:

• Money leaves the banking system.
• Bank reserves decrease.
• Lending decreases.

Central bank sells bonds → Bank reserves decrease → Lending decreases → Money supply decreases

Effects of Contractionary OMO

• Interest rates tend to rise.
• Borrowing and spending decrease.
• Aggregate demand decreases.
• Inflationary pressure may fall.

Advantages of Open Market Operations

• Flexible and widely used.
• Can be implemented quickly.
• Allows precise control over liquidity.

Possible Limitations

• Commercial banks may not increase lending even with higher reserves.
• Effectiveness may weaken during severe recessions.

2. Minimum Reserve Requirements

Minimum reserve requirements are regulations requiring commercial banks to keep a certain percentage of deposits as reserves.

The reserve requirement influences the ability of banks to create money through lending.

Higher Reserve Requirements

If the central bank increases reserve requirements:

• Banks must keep more funds as reserves.
• Banks have less money available for lending.
• Money creation decreases.

Result:

• Money supply decreases.
• Aggregate demand may decrease.
• Inflationary pressure may fall.

Lower Reserve Requirements

If reserve requirements decrease:

• Banks can lend more money.
• Money creation increases.
• Money supply expands.

Result:

• Aggregate demand may increase.
• Economic growth and employment may rise.

Effect on the Money Multiplier

The reserve requirement directly affects the money multiplier.

\( \mathrm{Money\ Multiplier = \dfrac{1}{Reserve\ Ratio}} \)

Higher reserve ratios reduce the money multiplier.

Lower reserve ratios increase the money multiplier.

Advantages of Reserve Requirement Changes

• Strong influence on money creation.
• Directly affects bank lending capacity.

Possible Limitations

• Large changes may disrupt banking operations.
• Rarely adjusted frequently in many economies.

3. Changes in the Central Bank Minimum Lending Rate

The central bank sets a key interest rate known as the:

• Base rate
• Discount rate
• Refinancing rate

This is the rate at which commercial banks borrow from the central bank.

Lowering the Lending Rate

When the central bank lowers the lending rate:

• Commercial banks can borrow more cheaply.
• Commercial lending rates usually decrease.
• Borrowing by households and firms increases.

Effects of Lower Interest Rates

• Consumption increases.
• Investment increases.
• Aggregate demand rises.
• Economic growth and employment may increase.

Raising the Lending Rate

When the central bank raises the lending rate:

• Borrowing becomes more expensive.
• Commercial banks increase lending rates.
• Consumption and investment decrease.

Effects of Higher Interest Rates

• Aggregate demand decreases.
• Inflationary pressure may decrease.
• Economic growth may slow.

Transmission Mechanism

Changes in policy interest rates affect the economy through:

• Borrowing costs
• Savings behaviour
• Investment decisions
• Exchange rates

Advantages of Interest Rate Changes

• Widely used and flexible.
• Strong influence on aggregate demand.
• Clear signalling effect for markets.

Possible Limitations

• Effects may take time to occur.
• Consumers and firms may not respond strongly during recessions.

4. Quantitative Easing (QE)

Quantitative easing (QE) is an unconventional monetary policy used mainly during severe recessions or financial crises.

QE involves large-scale purchases of financial assets by the central bank.

Purpose of Quantitative Easing

QE is used when:

• Interest rates are already very low.
• Traditional monetary policy becomes less effective.

The goal is to increase liquidity and stimulate economic activity.

How Quantitative Easing Works

The central bank creates new electronic money and uses it to buy:

• Government bonds
• Financial assets

This increases money supply and reserves in the banking system.

Effects of Quantitative Easing

• Interest rates may decrease further.
• Bank lending may increase.
• Asset prices may rise.
• Investment and spending may increase.
• Aggregate demand may rise.

Wealth and Confidence Effects

Higher asset prices may increase:

• Household wealth
• Business confidence

This may encourage greater spending and investment.

Advantages of Quantitative Easing

• Provides liquidity during crises.
• Supports economic recovery.
• May prevent deflation.

Possible Risks and Limitations

• May increase inflation if excessive.
• May increase asset price bubbles.
• Benefits may mainly go to wealthier asset owners.
• Banks may still lend cautiously.

Comparison of Monetary Policy Tools

Expansionary vs Contractionary Use of Monetary Tools

Key Ideas:

• Central banks use several tools to influence money supply and interest rates.
• Open market operations affect bank reserves through bond transactions.
• Reserve requirements influence the money multiplier and lending capacity.
• Interest rate changes influence borrowing, spending, and investment.
• Quantitative easing is used during severe recessions when traditional policies become less effective.