Y1 35) Monetary Policy - Interest Rates, Money Supply & Exchange Rate

hi everybody monetary policy involves changes to interest rates the money supply and the exchange rate by the central bank of an economy in order to influence aggregate demand so very much like fiscal policy a demand side policy policies aimed to influence aggregate demand but unlike physical policy these policies will be enacted by a country central bank independent to the government and the mandate for these central banks around the world will predominantly be to control inflation in the UK the Bank of England's primary role is to hit a 2% inflation target so something to bear in

mind monetary policy can be both expansionary or contractionary expansionary monetary policy or any of these policies that try to boost aggregate demand whereas contractionary monetary policies at any of these policies above that aim to reduce aggregate demand let's see why a central bank would use either expansionary or contractionary monetary policy while the primary goal of central banks out there is to hit the inflation target so a major reason for using expansionary monetary policy would be to boost aggregate demand and to raise demand from inflation if the inflation rate is below target but inflation targeting is

not the only goal of central banks around the world absolutely not also within their mandate will be macroeconomic stability and part of that is also achieving the other macroeconomic objectives as well as hitting the inflation targets so for that reason expansionary monetary policy could also be to try and boost economic growth and reduce unemployment we get both when aggregate demand increases what about contractionary monetary policy why would central bank's look to use that well the primary reason why central banks would use contractionary monetary policy and want to reduce ad is again to hit the inflation

target so if inflation is beyond target and it needs to come back down towards target a reduction an ad can reduce demand print inflation and bring it towards the target rate but as I've said already macroeconomic stability will be another major goal of central banks around the world not just inflation targeting and that also involves protecting the financial sector guarding against financial sector collapse number two number three linked to that I'm not going to explain them in detail in this video two videos on in this playlist you'll see a video about contractionary monetary policy I'll

go into these in far more detail but number two is basically saying to prevent excessive growth of house prices and to prevent excessive credit in the economy that is borrowing by households and by businesses and the problem is that if too much so this is going on too much house price growth which is unsustainable too much credit and borrowing which is unsustainable there is a risk to the financial sector there is a risk of a crash there and a potential recession in the economy number three is the idea of balancing out economic growth reducing excess

debt and promoting more saving so if economic growth in an economy is very debt-fueled whether it's consumer spending or investment then higher interest rates for example can reduce the incentive to take out so much debt and that's more sustainable growth is promoted in the country but also to promote saving so savings are very low and that's dangerous for households and businesses higher interest rates providing an incentive to save which is important to but also contractionary monetary policy via reducing ad can also help in reducing the current account deficit very much a theoretical reason here that's

because as ad falls growth Falls incomes fall and therefore to be less spending on imports which in theory will Ameri a current account deficit from now on in guys I'm going to focus on expansion Airi monetary policy because as I've said I've made a separate video in this playlist about contractionary monetary policy so let's focus now on the different types of expansionary monetary policy well interest rates are their big daddy of monetary policy so even though we can talk about expansionary monetary policy being boosts to the money supply that's quantitative easing or reductions in the

exchange rate we're not going to go into those in this video I've covered QE in a separate video you can look at that but interest rates are very much there Big Daddy of expansionary monetary policy so that's what we're going to focus on here now expansionary monetary policy interest rate cuts will feed through a transmission mechanism before hitting the real economy and basically that means that an interest rate cut by the central bank will work through various channels affecting a variety of variables in the equation as it hits the real economy so don't think that

an interest rate is just one rate there are so many different interest rates out there in the economy and a cut in the central bank interest rate will affect a wide variety of interest rates in the economy and as that Central Bank rate cut fears through these different channels and hits the real economy we say the cut is working through the monetary policy transmission mechanism and here's what it is so the central bank would cut interest rates that's the expansion airy policy being used and that could well lead to lower credit card interest rates basically

lower borrowing costs for consumers and if that's the case it makes it cheaper for consumers to borrow it incentivizes more borrowing and incentivizes less saving that's gonna increase the marginal propensity to consume as consumers borrow they're going to be spending more on big-ticket items like cars like furniture like jewelry or some simple examples and therefore aggregate demand will boost as consumption Rises at the same time saving interest rates will fall interest rates is the cost of borrowing yes but it's also the rate of return on saving so the central bank cuts their interest rate interest

rates on savings accounts could fall in the economy as well and with that that reduces the incentive to save it increases the incentive to spend instead and therefore will increase consumption in the economy boost a B that way as central bank's cut their interest rate we can expect that mortgage rates mortgage interest rates across the economy will come down as well mortgages just a loan that individuals take out when they're looking to buy a house and for households or families that have Tracker rate mortgages or variable rate mortgages these mortgages have interest rates that will

follow this central bank rate so the central bank rate is cut then Tracker mortgage rates and variable rate mortgages will come down as well and that means that households will be paying less monthly towards their mortgage payments and that means they're gonna have more disposable income that's going to increase their marginal propensity to consume and there's boost consumption we can also link to lower interest rates on business loans these are very different loans and have different interest rates as well and if those interest rates come down it increases the incentive for businesses to borrow because

the cost of borrowing for businesses reduces if businesses borrow they could well use that money for investment purposes and boosting eighty that way also lower interest rates across the economy can well in the exchange rate and that's because savers have less of an incentive to save in this country if interest rates are lower and therefore they look to move their money out of the country that's known as hot money outflows for an economy hot money is savings that chase the best interest rate so if interest rates have relatively lower in one economy and the higher

elsewhere people with savings will move their money out of the country hot money outflows that will lead to an increase in the supply of a currency depreciating the currency and with a weak currency we get a boost to net exports in the ad equation and here is the impact on a diagram so if these channels actually work and we see the lower interest for its feed through into these higher variables in the ad equation then there's our ad shift to the right there we can see the increase in growth and reduction that unemployment and now

we can see the increase in demand pull inflation as well which might be desirable if inflation is below the target rate but crucially there is also a link between expansionary monetary policy and long-run aggregate supply now remember what I said monetary policy is a demand side policy so any link to LRS will just be a nice side effect it's not going to be the core ideal of what monetary policy is trying to do the core intention but there could well be this boost and that comes via an increase in investment so if interest rates on

business loans do come down and businesses do borrow more and invest then as we know investment can boost LRS via an increase in the quantity of capital and increase in the quality of capital and an improvement in the productive efficiency of the economy that's what investment does and so we see the improvements in long term growth rates as well as short-term growth rates via the increase in ad but as I said this is very much a nice side effect it's not the core intention it's a demand side policy this is the core intention of expansionary

monetary policy so that's it for this video guys thank you so much for watching I'll see you for the next video very important video as we look to evaluate expansionary monetary policy [Music]