3.5 Demand management - monetary policy

• Monetary policy is central bank control of money supply and interest rates

• Goals include low stable inflation, low unemployment, reduced business cycle fluctuations, long-term growth conditions, and external balance

• Commercial banks create money through lending

• Central bank tools include open market operations, minimum reserve requirements, base or discount rate changes, and quantitative easing

• Money demand and money supply determine equilibrium interest rates

• Diagram [HL]: equilibrium interest rate in the money market

• Nominal interest rates are not adjusted for inflation

• Real interest rates adjust nominal rates for inflation

• Calculation: real interest rate from data

• Expansionary monetary policy can close deflationary or recessionary gaps

• Contractionary monetary policy can close inflationary gaps

• Diagram: AD/AS showing expansionary and contractionary monetary policy

• Constraints include near-zero interest rates and low consumer or business confidence

• Strengths include incremental adjustment, flexibility, reversibility, and short time lags

• Evaluation considers effects on growth, unemployment, and price stability