Monetary policy

Monetary policy involves changing either the price of money – its interest rate – or the quantity of money, in order to control inflation.

The ‘monetary transmission mechanism’ shows how interest rates work their way through the economy, affecting asset prices, confidence, exchange rates, and finally on to the price level.

With the era of very low interest rates, central banks have turned to ‘quantitative easing’, which pumps money directly into the economy through a central bank purchasing financial assets. 

Monetary transmission mechanism

Expansionary monetary policy will shift the aggregate demand curve to the right, and contractionary policy will shift it to the left.

Monetary policy

Monetary aggregates

Most central banks use at least two measures of the money supply - a narrow measure and a broad measure.

In the UK, the measures are:

  1. MO, which is the narrow measure consisting of notes and coin in circulation (which is over 99% of the total) and bankers' operational balances at the Bank of England.
  2. The broader measure, M4 consists of the private sector's holdings of cash, and sterling deposits held by the private sector at both banks and building societies.

There are three basic measures in the US, including:

  1. The monetary base - the sum of currency in circulation and reserve balances - deposits held by banks and other depository institutions in their accounts at the Federal Reserve.
  2. M1, which is the sum of currency held by the public and transaction deposits at depository institutions, such as commercial banks, savings banks, and credit unions.
  3. M2, which is M1 plus savings deposits, small-denomination time deposits - which are issued in amounts of less than $100,000 - and retail money market mutual fund shares.

Video on macro-economic policies

Quantitative easing - QE

As a result of very low interest rates central banks have looked to pump money directly into the economy when growth has slowed or when economies enter a recession. QE involves the purchase of government bonds which lowers the interest rates (or yield) on these bonds.

The effect is to push interest rates down on other loans, such a mortgages. This makes it cheaper to borrow money, which encourages spending.

QE also works by stimulating asset prices - holders of bonds may now wish to invest in these other assets, which pushes up their prices. Asset holders across the economy may now feel more confident to spend money, which increases aggregate demand.

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