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By the end of this section, you will be able to:

  • Analyze whether monetary policy decisions should be made more democratically
  • Calculate the velocity of money
  • Evaluate the central bank’s influence on inflation, unemployment, asset bubbles, and leverage cycles
  • Calculate the effects of monetary stimulus

In the real world, effective monetary policy faces a number of significant hurdles. Monetary policy affects the economy only after a time lag that is typically long and of variable length. Remember, monetary policy involves a chain of events: the central bank    must perceive a situation in the economy, hold a meeting, and make a decision to react by tightening or loosening monetary policy. The change in monetary policy must percolate through the banking system, changing the quantity of loans and affecting interest rates. When interest rates change, businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars. Then it takes time for these changes to filter through the rest of the economy.

As a result of this chain of events, monetary policy has little effect in the immediate future; instead, its primary effects are felt perhaps one to three years in the future. The reality of long and variable time lags does not mean that a central bank should refuse to make decisions. It does mean that central banks should be humble about taking action, because of the risk that their actions can create as much or more economic instability as they resolve.

Excess reserves

Banks are legally required to hold a minimum level of reserves, but no rule prohibits them from holding additional excess reserves    above the legally mandated limit. For example, during a recession banks may be hesitant to lend, because they fear that when the economy is contracting, a high proportion of loan applicants become less likely to repay their loans.

When many banks are choosing to hold excess reserves, expansionary monetary policy may not work well. This may occur because the banks are concerned about a deteriorating economy, while the central bank is trying to expand the money supply. If the banks prefer to hold excess reserves above the legally required level, the central bank cannot force individual banks to make loans. Similarly, sensible businesses and consumers may be reluctant to borrow substantial amounts of money in a recession    , because they recognize that firms’ sales and employees’ jobs are more insecure in a recession, and they do not want to face the need to make interest payments. The result is that during an especially deep recession, an expansionary monetary policy may have little effect on either the price level or the real GDP    .

Japan experienced this situation in the 1990s and early 2000s. Japan’s economy entered a period of very slow growth, dipping in and out of recession, in the early 1990s. By February 1999, the Bank of Japan had lowered the equivalent of its federal funds rate to 0%. It kept it there most of the time through 2003. Moreover, in the two years from March 2001 to March 2003, the Bank of Japan also expanded the money supply of the country by about 50%—an enormous increase. Even this highly expansionary monetary policy, however, had no substantial effect on stimulating aggregate demand. Japan’s economy continued to experience extremely slow growth into the mid-2000s.

Questions & Answers

classical dichotomy and its components?
Romaisa Reply
what will happen to the demand curve when there is an inflation in an economy
Hamza Reply
From my view, I think the demand curve will shift inwards.
now it depends on what kind of inflation it is, depending on the type of inflation the movement of the demand curve can be stated.
yes it depends on the cause for inflation. if it caused by maybe an increase in money supply, the effect is neutral in the long term, therefore there are no effects on total output in the economy, except for an increase in price
but short term in general i think you could expect the demand curve to shift inwards as consumers experience a decrease in real income
source of capital for the sole trader
Dogbey Reply
borrowing from relatives, government grants, bank loans, personal savings, credit card etc.
Suppose you are holding 2000 in a checking account and the price level decrease by 20 %how much it will affect your purchasing power and why
Iqra Reply
Hi Iqra, will answer your question soon.
2000*0.2= 400 2000-400= 1600
a price level decrease is deflation. it means you'll be able to afford to buy more with your 2000 and your real income becomes 2000÷(100-20)=2500
the amount will decrease to 1600 and you can't be able to buy over this amount
As an economist student discuss how the pandemic covid19 can affect the aggregate demand and aggregate supply thereby leading to decrease in GDP and standard of living of citizens of nigeria
Fadila Reply
hi how can you help me?
qusai Reply
can you send me the notes
hello is what are you talking about?
unemployment and low inflation    .
Abdirizaq Reply
Structure/Organization Of The Federal Reserve
sorry guys in macroeconomics what is different between inflation and intrest rate? please example for pandemic related maybe?
Is this Aap for class 11 and 12 only not for graduation?
ankit Reply
yeah like for du MA entrance
Aree i m also asking
for du MA entrance. u shouldn't rely on app. Go for SAURABH SIR notes. available on flipkart.
ohh thanks
what is inflation
Bright Reply
hike in price
situation of rise in price with the fall in purchasing power of money
cycle of corruption
rise in price of a Nation economy in terms of trade
what is distruptive international trade?
meaning of inflation
Jayakumar Reply
increase in general prices level in an economy.
increase in general price level
The fall in standard of living because goods and services become expensive.
what is value added and how is it used in calculating GDP
Benedicta Reply
value added is final price of output minus cost of production. For example, let's say you make a shirt with raw materials that cost $20, and then sell the shirt for $35 added value would be 35-20=15. In calculating GDP, it is used to avoid double counting goods. Exp. eggs individually and in bread.
as the price of tickets rises from $200 to $250, what is the price elasticity of demand for business travelers, vacationers using midpoint method
Buumba Reply
@jb how do uget $300
It means you are measuring the cost against availability.
Explain how income taxes and transfer payments are used to stabilize the economy
Nakagwa Reply
reduce demand on scarce resources by reducing money supply.
sketch the graph of supply curve
Isamole Reply
why is not possible accept or reject any microeconomics theory explain
Amna Reply

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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