Unit 3.5 - Demand Management (Monetary Policy)

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A strategy designed to decrease economic activity by limiting the money supply, primarily through increasing borrowing costs.

contractionary monetary policy

Transactions conducted by the central bank involving the buying or selling of government securities to affect interest rates.

open market operations (OMOs)

business confidence

The level of optimism that businesses have regarding future economic conditions, which affects their investment decisions. Low business confidence can hinder economic recovery, even when interest rates are low.

A central bank creating new money to buy government bonds and other securities from commercial banks, used to raise the money supply when interest rates are already near zero.

quantitative easing (QE)

A situation where the interest rate cannot be lowered further, rendering traditional monetary policy ineffective.

liquidity trap

The actions taken by the central bank to buy or sell securities to influence rates.

OMOs

The lowest proportion of customer deposits that a commercial bank is legally required to hold rather than lend out.

minimum reserve ratio

The official interest rate that the central bank charges commercial banks for borrowing.

minimum lending rate (MLR)

Bank reserves

The cash reserves that banks hold, which increase liquidity and facilitate lending and investment. When central banks create new money, it increases bank reserves electronically, similar to printing money, thus boosting economic activity and helping to avoid deflation.

Base rate / discount rate / refinancing rate

The official interest rate set by the central bank for lending to commercial banks, influencing other interest rates in the economy. It serves as a benchmark for loans and credit transactions.

Minimum reserve requirement (MRR)

The minimum percentage of deposits that banks are mandated to keep as reserves at the central bank. This requirement ensures banks have sufficient liquidity to meet withdrawal demands and supports financial stability.

bank run

A situation in which a large number of customers withdraw their deposits from a bank simultaneously due to concerns about the bank's solvency. This can lead to liquidity problems for the bank, as it may not have enough cash on hand to meet withdrawal demands, potentially resulting in bank failure.

State the formula: $1,000 × (1 ÷ 0.1)

$1,000 × (1 ÷ 0.1) = $10,000 – $1,000 = $9,000 Example showing that with a 10% reserve ratio, a $1,000 initial deposit increases the money supply by $9,000 (credit created).

State the formula: $1,000 × (1 ÷ 0.2)

$1,000 × (1 ÷ 0.2) = $5,000 – $1,000 = $4,000 Example showing that raising the reserve ratio to 20% reduces the increase in the money supply from an initial $1,000 deposit to $4,000.

State the formula: Money multiplier

Money multiplier = 1 ÷ Reserve ratio Formula used to calculate how much an initial deposit can ultimately increase the money supply given the reserve ratio.

Credit creation

The process by which commercial banks create money through lending, using deposits from savers. This mechanism increases the money supply in the economy and facilitates borrowing for consumption and investment.

Inflation targeting

A monetary policy strategy where central banks set a specific inflation rate to achieve economic stability. This approach aims to control inflation while supporting sustainable economic growth and employment.

Interest rate policy

The use of interest rates by central banks to influence economic activity. Adjusting interest rates can expand or contract economic growth in pursuit of macroeconomic goals like inflation control.

Money multiplier

A formula used to determine how much the money supply increases based on the initial deposit and the reserve ratio. It illustrates the potential expansion of money through the banking system.

economic stability

A stable economic environment that promotes long-term growth by achieving macroeconomic objectives such as stable prices, lower unemployment, and sustainable economic growth. Economic stability fosters confidence among consumers and firms, encouraging investment and reducing fluctuations in the business cycle.

The approach used to regulate the amount of lending by banks through reserve management.

Credit control

The authority that has the exclusive right to produce and distribute the official currency of a nation.

Sole issuer of legal tender

The entity responsible for regulating interest rates and currency exchange to meet national economic goals.

Executor of monetary policy

The institution that manages state funds and reserves.

Government’s bank

The institution that regulates commercial banks and controls cash reserves.

Bankers’ bank

The role of the central bank in providing loans to commercial banks to avert financial crises.

Lender of last resort

Cash reserve ratio

The percentage of deposits that commercial banks are required to hold as reserves at the central bank. This ratio helps manage credit creation and can be adjusted to control lending during economic fluctuations.

Legal tender

The sole form of money recognized by law for settling debts, which is issued by the central bank. It helps to control the money supply and ensures uniformity and confidence in the monetary system.

monetary authorityHL

The central bank or regulatory body responsible for managing a country's monetary policy, including controlling the money supply and interest rates through various tools.

tools of monetary policyHL

The methods used by a central bank to influence the money supply and interest rates, including open market operations, reserve requirements, and changes in the minimum lending rate.

A form of public sector borrowing used to fund governmental activities.HL

government securities

The process dependent on the assumption of no withdrawals by customers.HL

Money creation by commercial banks

The quality of investments guaranteed by the issuing authority.HL

Safety of government securities

Commercial banksHL

Financial institutions that accept deposits and provide loans, playing a crucial role in money creation through lending and facilitating transactions. They operate under the regulations set by the central bank and are involved in open market operations, which influence the money supply in the economy.

Public sector debtHL

The total amount of money that a government owes to creditors, often financed through the issuance of government securities. These securities are considered low-risk investments as they are backed by the government.

money creationHL

Expansion or contraction of the money supply by the central bank, chiefly through open market operations — buying government securities to raise it, selling them to reduce it — and through quantitative easing and the minimum lending rate.

The market where the demand and supply of money determine interest rates.HL

Money market

The quality that allows money to be readily used for transactions.HL

Liquidity

The rate determined by the intersection of the demand for and supply of money.HL

equilibrium interest rate

A condition where the effective return on savings is outpaced by inflation, leading to diminished value over time.

negative real interest rates

The actual percentage charged or earned on finances without accounting for inflation.

nominal interest rate

The desire of households and firms to hold cash and deposits rather than save them, so as to finance consumption and current spending.

demand for money

The rate that reflects the impact of inflation on the return to savers and the cost of debts to borrowers.

real interest rate

State the formula: Nominal return

Nominal return = Principal Nominal interest rate Multiply the principal by the nominal interest rate to obtain the nominal monetary interest earned.

State the formula: Real interest rate

Real interest rate = Nominal interest rate  - Inflation rate Subtract the inflation rate from the nominal interest rate to get the real interest rate.

State the formula: Real return

Real return = Principal Real interest rate Multiply the principal by the real interest rate (nominal minus inflation) to obtain the real monetary interest earned.

Deflationary (recessionary) gap

A situation where the economy operates below its potential output, leading to reduced demand and lower prices. Central banks may lower interest rates to close this gap and stimulate economic activity, preventing deeper recessions.

House prices

The values of residential properties, which significantly impact consumer confidence and consumption expenditure. Changes in house prices can influence economic growth, as they are often the most valuable asset for households.

Reserve requirement

The minimum amount of reserves that banks must hold against deposits, which influences the money supply. A lower reserve requirement allows banks to lend more, thus reducing interest rates and stimulating economic activity.

quantitative easing

An expansionary monetary policy where a central bank creates money to purchase financial assets, such as government bonds, to lower interest rates and increase money supply. This aims to stimulate economic activity by encouraging borrowing and spending, thus boosting aggregate demand.