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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

list three possible ways of addressing and adverse balance of payment
Meribah Reply
when MPs is 0.3 and autonomous consumption is 30billion what is d consumption expenditure
queen Reply
what is macroeconomic?
Consumption expenditure becomes: C = 30b + 0.3Y without lump sum tax and C = 30b + 0.3Yd with lump sum tax
Macroeconomics deals with the study of the behavior of aggregate individuals, firms or government in an economy in relation to consumption patterns and decision making
If the government decrases spending by ksh. 500 billion what is the change in output given MPC is 0.75
Gichana Reply
how can policy makers strike the balance between inflation and unemployment?
Oreva Reply
c=800 + 0.75y i=500 G=900 compute the equilibrium level of national output
Omar Reply
y=c+I+g+(X-M) y=800+.75y+500+900+0 y-.75y=2200 .25y=2200 y=2200/.25 y=8800=national level of output
Please tell me the current crr, repo rate etc
Ranjeeta Reply
cash reserve ratio is the amount that is deposit by the commercial bank in Central bank.... n repo rate is a loan interest amount
what is slr madam sahar
jo amount bank reserve rakhti hai bank mai customers k liye jese ATM mai ya bank mai rakha hota hai, wo slr hota hai
pakka sahi hai
good joke
Argentina Lose !!😭😭
SLR refers to that portion of total deposits of a commercial bank which it has to keep with itself in the form of cash reserve
What is cash crop?
Ranjeeta Reply
commeciaal crops
So jowar is not cash crop?
anything which is plant inorder to sell in the market
How demand deposits are different from savings?
can unemployment be a factor of inflation?
David Reply
yeah it has an impact on cost push inflation
microeconomics is individual firms and macroeconomics is a large as a full
kendra Reply
That's true 👍
word micro means small and tiny part. word macro means large and big part.
is unemployment another cause of inflation?
can I say unemployment can cause inflation?
no. unemployment can possibly lead to deflation
if their are no production am I correct to say inflation will occurs
one of the causes of inflation is excess demand. if there's no production there would be no demand so no inflation
if we take a look at inflation, it occur because of low production. High price chasing few goods.
So are you saying demand creates supply?
to an extent because if s9mething is demanded, it's likely to be supplied
OK am still confused, if there is unemployment low production, and employment high production, inflation high increase in price, how can production be high and we are faced with inflation? When inflation is referred to higher price chasing few goods.
if the demand is increased , what is the graphics on it?
Tadesse Reply
what is macroeconomics
Prosenjit Reply
large-scale economics, such as interest rates or the gross national national product rate of of a country
Macroeconomics: is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.
well said
hello everyone, would like to ask a favor... i need your help to answer this problem: Assume that equilibrium GDP is 400B; potential GDP is 500B, the marginal propensity to consume is 9/10, the interest rate is 8%, investment spending is P20B, the money supply is 120B, and the reserve requirement
is 1/10. By how much and in what direction should the Fed change the monetary base?
what are the factors that influence surplus budget? and its effects
Christopher Reply
what is credit creation
how monetary and fiscal policy affect money supply? on economy
Christopher Reply
what is hyperinflation
David Reply
what is stagflation
in an economy when there is both inflation & unemployment prevailing at the same time.
@david - hyperinflation is very rapid inflation; it is sometimes reckoned to set in when price increases exceed 50 percent per month. Such rapid inflation not merely makes money useless as a store of value, but seriously affects its use as a medium of exchange
@yogesh: the one you are describing is Stagflation
I was answering to Riaz's querry.
Sorry, didn't see the question
what is credit creation?
what are the factors that influencing surplus budget
may I ask master level questions on this chat?
saddiq Reply
am so confused about the concept of scarcity. can u hlp me
 · Concepts of Scarcity. Scarcity refers to the condition of insufficiency where the human beings are incapable to fulfill their wants in sufficient manner. In other words, it is a situation of fewer resources in comparison to unlimited human wants. Human wants are unlimited.
what is PPC
Production possibility curve is a curve that shows different possibilities of production of a set of two good which can be produced with the given resources
micro vs macro which is complex in your view?

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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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