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Micro- and macroeconomics - Monetary and fiscal policy.pdf

Micro- and macroeconomics - Monetary and fiscal policy.pdf...

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Monetary and fiscal policy Micro-and macroeconomics
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Monetary control The central bank can control the money supply by using open market operations to determine the monetary base, and by using reserve requirements and the discount rate to determine the money multiplier. Easy in theory but not in practice. It is hard for the central bank to control the monetary base because it is also the lender of last resort. The lender of last resort lends to banks when financial panic threatens the financial system. When the commercial banks wish to increase lending and deposits they can always get extra cash from the central bank. 2
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Monetary control (2) Nor is the money multiplier easily manipulated. To affect it, reserve requirements must force banks to hold reserves they would not otherwise have held. This is a tax on banks, hurting their profits. Modern banks operating in global markets find ways around these controls. Precise control of the money supply is difficult. Most central banks no longer try. Instead they set interest rates. 3
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Interest rates and monetary control LL LL’’ Interest rate Real money holdings r 0 L 0 L 1 The money demand schedule LL is drawn for a given level of real income. If the central bank can fix the real money supply at L 0 the equilibrium interest rate will be r 0 . Alternatively, if the central bank sets the interest rate r 0 and provides whatever money is demanded, the money supply will again be L 0 . To control the money supply by using interest rates, the central bank must know the position of the demand schedule. Fixing an interest rate r 1 , the resulting money supply will be L 1 if the demand schedule is LL but will be L’ 1 if the demand schedule is LL’. r 1 L’ 1 Figure 1 4
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A Taylor rule What economic variables are correlated with the interest rate decisions of central banks? Professor John Taylor of Stanford University found that most central banks adjust interest rates in response to two variables, expected output (relative to potential output) and inflation. Following a Taylor rule , a central bank raises (lowers) interest rates if inflation and output are expected to be above (below) their target levels. Alternatively, an inflation target implies interest rates are adjusted to keep inflation within a narrow range. 5
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Interest rates in a simple Taylor rule TR Interest rate Output A Taylor rule When output equals potential output Y*, the central bank sets the interest rate at r*. Higher output leads to interest rates above r*, and lower output leads to interest rates below r*. The steeper the slope of Taylor rule TR the more the central bank is prepared to alter interest rates in order to stabilize output. r* Y* Figure 2 6
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Interaction of the markets for goods and for money We now examine the interaction of the markets for goods and for money.
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