Summary of Monetary Policy
What does it affect?
- Consumption (C)
- i/r decrease
- Cost of borrowing decrease
- Consumers more willing able and willing to purchase big-ticket items
- (C) of big-ticket items increase
- Furthermore, opportunity cost of holding money decrease
- Savings (S) decrease and quantity of money demanded increase*
- People spend more -> (C) increase
*quantity of money demanded = amount of money held as cash in economy NOT including money saved in bank
2) Investment (I)
- i/r decrease
- Previously projects which have IRR < i/r now have IRR > i/r
- Projects that were previously unprofitable now becomes profitable
- Level of investment increase -> (I) increase
3) (X-M)
- i/r increase
- Hot money inflow
- Demand for domestic currency increase [insert Forex Market graph]
- Equilibrium price of domestic currency increase -> domestic currency appreciates
- Assuming Marshal-Lerner Condition (MLC)* is satisfied (PEDx + PEDm > 1)
- Exports are more expensive in terms of foreign currency -> (X) decrease
- Imports are cheaper in terms of domestic currency -> (M) increase
- (X-M) decrease
*MLC only used for change in exchange rate (appreciation or depreciation of currency), NOT due to inflation or taste and preference etc.
4) Foreign Direct Investment (FDI) *2 ways to argue
- i/r increase
- As interest rates causes a change in exchange rate, FDI is affected. (further elaborated below)
Effectiveness of Monetary Policy
- In less developed countries, where securities market is relatively undeveloped, Central Bank may not have the ability to conduct open market operations (sell/purchase government securities) at a scale substantial enough to create the desired change in money supply. Therefore, monetary policy is not effective in changing i/r and bringing about the government’s desired outcome.
- During a recession, and gloomy economic outlook, economy is in liquidity trap, hence changing money supply will unlike change interest rates, hence monetary policy is ineffective and is unable to bring about the desired change in AD.
- Consumer’s confidence affects the elasticity of of the Marginal Efficiency of Investment (MEI) curve.
- During recession, consumer confidence in the economy drops, therefore MEI curve is likely to be inelastic, and as government adopt expansionary monetary policy and decrease interest rate, it will likely lead to a less than proportional increase in investment levels.
4) Extent of hot money inflow/outflow
- Money supply decrease
- i/r increase
- Hot money inflow
- Money supply increase
- Negate increase in i/r
-> Effect of hot money flow depends on the significance of hot money in the economy
- eg. In SG, which is a small and open economy, hot money inflow greatly increase money supply and will like negate the initial decrease in money supply by the government/ central bank, thus monetary policy is ineffective.
- eg. In USA, which is a large and less open economy, hot money inflow is likely to be insignificant to the initial decrease in money supply by the government/ central bank, therefore i/r will still increase and bring about the desired outcome -> monetary policy is effective.
Summary of Exchange Rate Policy
How does government regulate?
Through currency manipulation: Where government or Central Bank buys or sell foreign currency in exchange for domestic currency with the intention of influencing exchange rate.
Appreciate domestic currency:
- Increase demand OR decrease supply
- Government increase demand of domestic currency by purchasing domestic currency from forex market using foreign currency from foreign exchange reserve*
Depreciating domestic currency:
- Decrease demand OR increase supply
- Government increase supply by buying foreign currency from forex market from the selling of domestic currency from government reserve (??? what issit called, reserves in dom currency)
*Foreign exchange reserves are held in foreign currency ONLY (primarily USD) and derived from BOP surplus. (Foreign countries buy domestic currency using foreign currency, then use the domestic currency to buy domestic G&S)
What does it affect?