Class notes
Economics 244 - Monetary Policy
- Course
- Economics 244
- Institution
- Stellenbosch University (SUN)
Summary of the lectures presented during the 'Monetary Policy' section of Economics 244 in the year 2020.
[Show more]
2 reviews
By: deklerkneena4 • 3 year ago
By: MattMcCree • 3 year ago
Content preview
Economics 244Monetary Policy
1. Macroeconomic Policy
In South Africa, we have a market economy. This means that the principle of supply and demand
solves the economic problem of scarcity. Therefore, supply and demand determine the equilibrium
price and quantity. However, the market doesn’t always deliver the result that is acceptable to the
government as the representative of all of us. In cases as such, the government will use policies to
change the market outcome (market failures). If the government does not rectify these market
failures, the situation will worsen. This moves from market failures to government failures. The best
way to think of this is to think of policy as something that the government does to better a situation.
However, the end result is not necessarily better than that in which the market originally gave.
It is important to differentiate between stability objectives and structural objectives. Stability
objectives refers to stability in economic activity – exchange rates; the internal price level; the
financial sector. Structural objectives refer to the maximum long-term growth and employment;
equitable distribution. It is important, here, to note the extremely high levels of unemployment
South Africa is facing, and how the coronavirus has worsened this further.
2. Monetary Policy: A Broad Overview
2.1. Definitions and Objectives
Monetary policy is aimed at the stabilization objectives. Maximizing long-term economic growth is a
structural objective. Finance officials are thus criticized by people who don’t understand this because
they aren’t stimulating economy. However, stimulating the economy is not the task of the monetary
authority. In saying this, by achieving stability objectives, monetary authorities create a conducive
environment to maintain the structural objectives and thus, enabling maximization of long-term
economic growth. There are 4 stability objectives:
Stability with regard to economic activity
Stability with regard to the exchange rate
Stability with regard to the internal price level (low rates of inflation)
Financial sector stability
Should monetary policy be trying to obtain all of these objectives at one point in time? Theoretically,
the focus should be on one objective at a time, but in practice we see that this is not always the
case.
If we look at monetary policy from a historical perspective, we see that the specific stability objective
focused on has changed over time. Monetary authorities have focused mainly on internal price level
stability (low inflation). As they have gotten inflation under control, they generally start looking at
stabilizing economic growth. This is shown definitively by the Taylor Rule. The Taylor Rule states that
the monetary policy decisions are made taking into account both the inflation and economic growth
rates. This is the case in many countries, South Africa included.
After the global financial crisis, the focus of monetary authorities shifted to financial sector stability.
Monetary authorities have realized that they need additional instruments to prevent future financial
crises and have since made use of macroprudential instruments to prevent instability.
2.2. 2008/2009 Global Financial Crisis
Th global financial crisis of 2008/2009 was, in essence, an international liquidation and financial
sector solvency crisis. For monetary policy purposes, the following 3 questions need to be answered:
, 1. Was monetary policy a cause of the crisis?
Monetary policy was considered to be a cause because interest rates were kept too low for too long,
which ultimately led to an asset price bubbly the burst. US monetary authorities kept rates low to
comply with the policies that were in place at the time. So, what happened with these interest rates
that were kept too low? In the housing market, a rapid rise in the prices of houses was seen and
borrowing funds to buy houses became very cheap. When the asset bubble eventually burst, the
banks who leant out funds were in a crisis, and the property value (which was initially used as a
security) was lower than the outstanding loans.
2. What was the appropriate role for monetary policy in this crisis?
The focus of monetary authorities shifted to the instability of the financial sector. Monetary
authorities pumped liquidity into the financial sector on a major scale to ensure stability. This
response was deemed appropriate given the circumstances.
3. Given that monetary policy was a cause, what should future monetary policy look like to
prevent a reoccurrence?
Prior to this crisis, there was a consensus that monetary authorities would only react to instability in
the financial sector if it impacted national monetary policy objectives of inflation and stability in
economic growth. Since the crisis, this consensus has shifted. The norm now is that monetary policy
should be preventative, reacting to financial abnormalities as the occur.
Another consensus showed that monetary authorities require more than just short-term interest
rate to keep inflation under control to achieve financial sector stability. These instruments are
macroprudential instruments and they differ from the traditional monetary policy instruments.
2.3. Monetary Policy Since the Global Financial Crisis
When looking at monetary policy since the global crisis, it is important to look at the countries that
were greatly affected by it. We start off by looking at extremely accommodating policy. This was
directly after the financial crisis, due to the low level of economic activity. The following could be
seen:
Extensive Quantitative Easing (QE): This is when a central bank buys financial assets (usually
government bonds) in the economy where interest rates are very close to being 0%. The
objective of this is to lower long-term interest rates, thereby incentivizing firms to borrow
money to increase the production capacity. Should this happen, economic activity will be
boosted. There is an inverse relationship between the price of a financial security and its
interest rate. Thus, when the central bank purchases government bonds, the demand for
bonds increases, the price of bonds increase and the interest rate/return on bonds
decreases.
Very low (and even negative) nominal policy interest rates: These policy interest rates
impact directly on short-term interest rates within the economy. The expectation was that
these low interest rates would incentivize borrowing and spending within the economy.
Whether or not this happened is unclear.
The use of explicit forward guidance: This is when central banks keep interest rates at low
levels for an extended period of time. Central banks found that even with very low interest
rates, firms were not investing in additional production capacity. The idea of explicit forward
guidance is to provide certainty to firms that interest rates will stay low for a prolonged
period of time, and in this way, provide the incentive for firms to borrow and invest in
additional production capacity.
The ‘normalization’ of monetary policy commenced in 2016 in the US. This entailed the increase in
the policy interest rate again in order to be in a position to stimulate the economy be decreasing the
interest rate. This was not a viable option at the lower policy interest rates.
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through EFT, credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying this summary from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller stelliesstudentt. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy this summary for R80,00. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
73243 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy summaries for 14 years now