Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024: Economics (CFA Level I)/Monetary Policy

Monetary Policy

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Roles, Objectives, and Functions of Money5 min

Central banks are the cornerstone of monetary policy, fulfilling critical roles such as issuing currency, regulating the payment system, and acting as a lender of last resort. Their primary mandate is usually price stability (controlling inflation), balanced by goals for employment and growth. Money itself acts as a medium of exchange, unit of account, and store of value. It is categorized into 'Narrow money' (highly liquid) and 'Broad money' (includes less liquid assets).

Key Points

Primary objective: Control inflation.
Roles: Currency supplier, banker to gov/banks, lender of last resort.
Money functions: Medium of exchange, Unit of account, Store of value.
Narrow Money: Currency + Checkable deposits.
Broad Money: Narrow Money + Liquid assets.

Tools of Monetary Policy and the Multiplier Effect6 min

Central banks use three primary tools to influence the money supply: Open Market Operations (buying/selling securities), the Policy Rate (refinancing rate), and Reserve Requirements. Through fractional reserve banking, the banking system amplifies the initial money supply. The money multiplier is calculated as 1 divided by the reserve requirement. For example, a 10 percent reserve ratio results in a multiplier of 10, meaning an initial deposit can theoretically generate 10 times that amount in total money supply.

Key Points

Tools: Open Market Operations, Policy Rate, Reserve Requirements.
Expansionary: Buy securities, lower rates, lower reserves.
Contractionary: Sell securities, raise rates, raise reserves.
Money Multiplier = 1 / Reserve Ratio.
Total Money Created = New Deposit / Reserve Ratio.

Transmission Mechanism and Economic Theories5 min

The transmission mechanism explains the chain reaction from interest rate changes to inflation. An increase in rates typically lowers asset prices and growth expectations, appreciates the currency, and dampens demand. The Quantity Theory of Money (MV = PY) suggests that money supply growth primarily drives inflation in the long run (Money Neutrality). Central banks may target inflation directly via interest rates or target exchange rates, which ties their domestic policy to another country's economic conditions.

Key Points

Transmission: Rates -> Asset Prices -> Demand -> Inflation.
Quantity Theory: MV = PY.
Money Neutrality: Money affects prices, not real output, in the long run.
Exchange Rate Targeting: Imports inflation from the target currency country.

Policy Assessment and Fiscal Interaction6 min

To assess policy stance, analysts compare the policy rate to the neutral interest rate (Real Trend Rate + Expected Inflation). A policy rate below neutral is expansionary; above is contractionary. Effective policy requires central bank independence, credibility, and transparency. Finally, the interplay with fiscal policy is crucial: for instance, expansionary fiscal policy combined with contractionary monetary policy typically results in higher interest rates, impacting private sector spending.

Key Points

Neutral Rate = Real Trend Rate + Long-run Expected Inflation.
Policy Rate < Neutral Rate = Expansionary.
Effective qualities: Independence, Credibility, Transparency.
Exp Fiscal + Cont Monetary = High Interest Rates.
Liquidity Trap: Policy ineffective when people hoard cash.

Questions

Question 1

Which of the following is considered the primary objective of most central banks?

Monetary Policy

Questions

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