Monetary Policy: Easier does it

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Table of Contents

Introduction
Analysis
Evaluation
Conclusion
References

Introduction

The monetary easing that the fed has been implementing for some time now is seen to bear fruits. People are wondering whether the impressing report from the job market of January will actually prevent the Fed from implementing monetary expansion. Ben Bernanke, the Fed chairman, agreed there were some improvements though he was cautious that many of the same reports across the economy were to be received for them to back off. ”

We would have to get more and better reports like this one to take that option off the table”, he said. Unemployment and inflation are to be put on check, at least for the time being. “The problem, as I see it, has been that policy has not been loose enough to clear labour markets, mostly because it’s hard to move the policy rate down to the market-clearing real interest rate when the market-clearing real interest rate is negative”, the author stated.

Analysis

The article is about monetary policy and its effectiveness to the economy where it is applied. It touches on macroeconomic issues which involve: inflation, unemployment, interest rates, economic development and income distribution.

Monetary policy includes activities by the government, central bank or the monetary authority of a country to regulate the supply of money to the economy and interest rates to achieve stability and economic growth.

In order to achieve its targets the monetary policy uses various mechanisms which include the open market operations, reserve requirements and discount window rates all of this changing the interest rates.

It should be noted that unless there is equity in income distribution, economic growth will not translate to economic development, since the growth will not affect living standards of the poor. Gross domestic product (GDP) is the total output in an economy and is therefore mostly used to measure economic growth.

A person is referred to as being unemployed when he/she is willing, able to work and actively looks for employment but can not get a job in the economy. This definition does not however include people who are unable to work or who have chosen not to work for their personal reasons. Unemployment rate, which is the number of people who are unemployed divided by the number of people in the labour force, is used to indicate the state of employment in the economy.

On the other hand, inflation is defined as the general increase in overall price of commodities in the economy over time. It may also be termed as the continuous decline in the purchasing power of people through a certain period of time. Too much inflation is harmful to the economy however a certain rate of inflation is required for economic growth to take place. When inflation is coupled with high rate of unemployment and slow economic growth the situation is known as stagflation.

During inflation times, contactionary monetary policy is pursued which reduces amount of money available for spending hence reducing demand which in turn pulls prices down. Taking bonds for example, a decrease in interest rates make bonds less attractive hence people choose to invest forcing bond suppliers has to reduce their prices to get buyers.

Figure 1

Reduction in amount of money in circulation reduces demand hence shifting aggregate demand curve from AD1 to AD2. The short run supply curve remains constant which lead to decrease in GDP from Y1 to Y2 hence decrease in price from P1 to P2. However, decrease in GDP leads to increase in unemployment rate due to the inverse relationship between inflation and unemployment.

For the rate of unemployment to be reduced economic growth needs to be boosted and investment should be increased while saving is reduced.

Figure 2

Decrease in interest rates makes borrowing cheaper while returns on saving reduce; hence people increase their investments. In figure 2 above, reduction in interest rates from R₂ to R₁ increase investments level from I₁ to I₂ this will in turn increase demand for labour hence reduce unemployment. Economic growth can also be boosted if the government increases its spending thus increasing aggregate demand through expansionary fiscal policy.

Evaluation

Though reduction in interest rates boosts spending, it only does so if the existing rates are not too low. In a situation where the nominal interest rates are near or equal to zero the monetary policy tools are unable to stimulate the economy as there is no room for interest rates to decline further. Unemployment can only be reduced by reducing interests only if unemployment rate is above natural rate of unemployment otherwise the move would lead to increase in wages hence inflation.

Conclusion

The monetary policy plays an important role in maintaining stability in the economy and any wrong move might lead to economic disaster. Though uncertainty clouds the monetary policy makers credibility of the monetary authority helps in achieving the target goals.

References

‘Easier Does it’, The Economist, Web.

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Monetary Policy: Easier does it

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