Conventional and Unconventional Monetary Policies

Monetary policy is a macroeconomic policy which first appeared in the General Theory of Employment, Interest and Money written by John Maynard Keynes in 1936. Students can get a copy of the book from their economics tutor in their economics tuition class. It is a very good read. Ironically, Keynes did not think that the policy would work due to several factors such as a low interest elasticity of investment. However, Milton Friedman revived monetary policy in the 1950s by pioneering the Monetarist School of Thoughts. Ironically again, Milton Friedman argued against the use of monetary policy. The central idea of Milton Friedman’s argument is that central bankers are notoriously incapable of appropriately controlling the money supply. As a result, inflation is always and everywhere a monetary phenomenon. According to Milton Friedman, if the central bank increases the money supply rapidly, assuming the production of goods and services does not increase at the same rate, it may lead to a situation of too much money chasing too few goods resulting in inflation. Students can consult their economics tutor in their economics tuition class to gain a better understanding of inflation.

Conventional Monetary Policy

Today, monetary policy has been widely considered to be a standard policy in the policy toolbox of policy-makers. This is especially true with the advent of unconventional monetary policy which is commonly known as quantitative easing. In order to understand unconventional monetary policy, one need to first understand the transmission mechanism of conventional monetary policy. Students can learn conventional monetary policy from their economics tutor in their economics tuition class. Conventionally, monetary policy works through decreasing interest rates through decreasing interbank rates which are known as federal funds rates in the United States. More specifically, assume that the US economy is in a recession. If the Federal Reserves wish to boost the economy, it can conduct an open market purchase. What this means is that the Federal Reserves can purchase government securities in order to increase the money supply. In doing so, the amount of bank reserves will increase which will make it easier for banks to borrow from each other. When this happens, banks will lower the interest rates which they charge each other which are commonly known as interbank rates. In the United States, interbank rates are called federal funds rates and the average is called the effective federal funds rate, or simply, the federal funds rate. As banks in the United States borrow from each other rather than from the central bank due to the fact that interbank rates are lower than the bank rate, a fall in interbank rates will lead to a fall in the level of interest rates in economy. Accordingly, when interest rates fall, the level of consumption and investment in the economy will rise which will boost the economy. Students can learn the relationship between interest rates and consumption and investment from their economics tutor in their economics tuition class.

Unconventional Monetary Policy

The question was, β€œCould monetary policy still be effective when interbank rates fall to near-zero. The answer was provided by proponents of quantitative easing in the 1990s. According to the proponents of quantitative easing, which is an unconventional monetary policy, when interbank rates are near-zero, the central bank can increase the supply of money by a large extent to reduce interest rates. Students can get a copy of Economics: A Singapore Perspective from your economics tutor after the economics tuition class. The basic idea is that when the supply of money is increased aggressively, the amounts of reserves which banks are holding will increase rise substantially. It is important to note that although it is essential for banks to hold reserves for various reasons, holding excessively reserves is an unwise decision. Therefore, when banks find themselves holding excessive reserves to the rapid increase in the supply of money, they will increase leading and this will lead to an increase in the supply of loanable funds which will result in a fall in interest rates. As stated earlier, when interest rates fall, the level of consumption and investment in the economy will rise which will boost the economy. Students can learn how a change in interest rates will inversely affect consumption and investment from their economics tutor in their economics tuition class.

Edmund Quek

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