Tools and stances
How central banks influence AD.
Monetary policy = central bank's use of tools to influence aggregate demand, primarily through interest rates and money supply.
Main tool: official policy interest rate. Examples:
- US Fed: Fed Funds Rate.
- ECB: Main Refinancing Rate.
- BoE: Bank Rate.
Changes to this RATE cascade through:
- Mortgage rates.
- Business loan rates.
- Savings interest.
- Currency value (higher rates attract capital β appreciation).
Expansionary (loose) monetary policy:
- Cut policy rate.
- Reduce reserve requirements.
- Quantitative easing (buy assets to inject reserves).
- Forward guidance (signal future rates will stay low).
Effects: cheaper borrowing β households spend and invest more; firms invest more; currency depreciates β exports rise. AD shifts RIGHT.
Contractionary (tight) monetary policy:
- Raise policy rate.
- Sell assets (quantitative tightening).
- Raise reserve requirements.
Effects: costlier borrowing β less spending; currency appreciates β fewer exports. AD shifts LEFT.
Other tools:
- Quantitative easing (QE): central bank buys government bonds (or other assets) from banks β raises bank reserves β pushes down long-term interest rates. Used when policy rate already at zero (2008 onwards in major economies).
- Forward guidance: communicating future policy direction to shape expectations.
- Reserve requirements: minimum reserves banks must hold (used more in emerging markets).
- Yield curve control: directly target long-term rates (Bank of Japan).
Inflation targeting. Most central banks aim for ~2% CPI inflation, adjusting policy to maintain it. Pioneered by New Zealand (1989), now standard.
Central bank independence. Modern central banks (Fed, ECB, BoE) make rate decisions WITHOUT government interference β to credibly anchor inflation expectations. Evidence suggests independence reduces inflation without sacrificing growth.
- Main tool: policy interest rate.
- Expansionary: lower rates β AD right.
- Contractionary: higher rates β AD left.
- Modern: QE, forward guidance.
- Inflation targeting + independence.