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Monetary Policy: the challenge of interest rates
Published on October 29, 2015 21 min
My name is John Hearn. I'm a Senior Lecturer at the IFS University College, London. I'm going to talk to you about Monetary Policy: The Challenge of Interest Rates.
Monetary policy is defined as the central bank managing the overall level of aggregate monetary demand in the economy, using two main policy levers. Firstly, it can manage the volume of money, leaving interest rates to be determined by market forces. Secondly, it can manage the price of money, or what is usually referred to as the interest rate. And that is the challenge posed by this lecture. Before we move on, please note that both monetary policy and fiscal policy make up the government's demand management policies. Fiscal policy is defined in the same way as monetary policy, that is, managing the overall level of aggregate demand. And the only difference is in the levers used. Where fiscal policy makes its adjustments through spending, taxation, and borrowing, monetary policy makes its initial adjustment to the volume of money or the price of money.
To understand why interest rates were chosen exclusively as the main policy lever by almost all central banks around the world, you need to understand the structure of the money supply. This incorporates two main components. These are cash, which is notes and coins, and the money created by bank lending, which we're going to refer to as credit money. Most people find it easy to understand that cash is money, although they find it difficult to grasp that more than 90 percent of money is a claim on cash that could not be honored at one point in time if everyone demanded their money in cash. This means that the whole monetary system functions as long as everyone holding money is confident that they can access cash whenever they need it. A simple rule is to remember that all cash is money, but not all money is cash. That is why the monetary system of advanced economies is often considered fragile and liable to be damaged by shocks which affect confidence. In addition to this, we also need to understand how this money supply is converted into monetary demand.