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13 - UNDERSTANDING INTEREST RATES AND MONETARY POLICY

In economic theory, the interest rate is often considered as a single rate "fixed" by the central bank to control inflation, and which has a negative relationship with the level of investment.  While this theoretical simplification is useful to understand the functioning of the economy, the reality is much more complicated.  There is not only one interest rate, but a range of different rates, extending from the short to the long run and from low to high degree of risk.  Monetary policy determines the official discount rate but exerts only an influence over the level of the others.  Finally, expectations about future economic growth play a more important role in determining investment than interest rates.  In this chapter we explain the nature of interest rates and how they are affected by the different instruments of monetary policy.  The focus, throughout the chapter, will be on the fundamental role of expectations in driving, not only the decisions of monetary policy, but also the future trend of the main economic variables.  Some themes of this chapter are taken up again in chapter 16 where business cycles are discussed.

( QUESTIONS FOR DISCUSSION

Q1"In the present macroeconomic situation, the requirements of non inflationary growth point to the importance of monetary policy in moderating demand where margins of spare capacity have virtually disappeared...It [monetary policy] should support a recovery of activity only where such margins remain large and there is little risk of inflation". (OECD Observer, August-September 1995, p. 48)

Is it possible or advisable, to attempt such fine-tuning for monetary policy? If the answer were yes, what monetary measures could be used to implement such a policy?

We have already seen in previous chapters the delicate relationship between inflation, unemployment and economic policy.  Monetary policy has a positive impact on activity only when actual GNP is below potential GNP.  Otherwise, if the economy already runs close to full utilisation of capacity, inflation occurs.  

While in theory the effect of monetary policy is clear, the relationship between money supply and inflation is now less predictable than it once was.  The variables we are dealing with are not directly observable, their estimates can be biased, predicted effects can be lagged, and the final outcome of the policy can be influenced by side-effects.

Using the AS-AD model, we show that monetary policy is effective only when the AS curve is horizontal (or positively sloping). If this is the case, as in figure 13.1, an easing of monetary policy (through a decrease in the interest rate) would sustain investment and economic activity, moving the AD curve outwards.  There are risks in implementing such a policy:

i) monetarists believe that inflation is always a monetary phenomenon. According to them, an increase in money supply only creates inflation.  If actual GNP is lower than potential GNP, real factors, e.g., rigidity in wages, have to be blamed.  If these are the expectations of the business community, monetary policy will be ineffective, fuelling inflation and endangering economic stability.

31/07/97

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