We are thinking about buying a new car and want a pre-approved loan. I can help you with that. What kind of car are you going to buy? He wants a fast sports car imported from Europe. I want a family car made in this country. Well, I cannot help you choose between the two, but I can tell you the price of that imported car may be rising soon. Why is that? Because the European Central Bank just raised interest rates to fight inflation in Europe. What's that got to do with the price of cars? Well, you can find out in this lesson. Hi. Professor Navarro here and welcome back to the power of macroeconomics. In this lesson, we're going to explore the mysteries of one of the most important discretionary policy tools nations use in their attempts to solve the problems of recession and inflation, namely, monetary policy. Monetary policy is a tool implemented by a nation's central bank. For example, America's central bank is known as the Federal Reserve or the Fed for short. Japan, has its Bank of Japan. And the European Union of Nations, has its European Central Bank, and so on. In a nutshell, expansionary monetary policy is used to fight recessions. It primarily involves increasing the money supply lower interest rates. Lower interest rates in turn are intended to directly stimulate investment in the GDP growth equation, and thereby engineer recovery. But also note that low interest rates will also indirectly stimulate the net export driver in the GDP growth equation. Just why is this so? Well, lower interest rates tend to weaken the value of a nation's currency, as measured by its exchange rate. In this key definition, a nation's exchange rate, represents the price of one nation's currency in terms of another nation's currency. For example, if the dollar-yen exchange rate is 100, 1 U.S. dollar exchange is a 100 Japanese yen. And if that exchange rate drops to 50, the dollar has weakened because one $1 can now buy only 50 yen. As to why lower interest rates in say the United States might weaken the U.S. dollar, this is simply because foreign investors will tend to invest less in the U.S., and more in other countries where interest rates are relatively higher. These investors can earn a higher return. And as foreign investment falls in response to falling interest rates, so too will the dollar's value and exchange rate, because foreigners are demanding fewer dollars. As to how a weaker currency might actually stimulate the net export driver in the GDP equation. I want you think about that now for a minute, and jot down some ideas of the various adjustments that occur on the export and import sides of the net export equation itself. And note, this is a tough question, but an important one, so give it a go before moving on. Okay, so how does a fall in interest rates engineered by a nation's central bank result in an increase in the net exports driver in the GDP equation? Well, this net export stimulus occurs because a weaker domestic currency makes that nation's exports cheaper, and therefore, easier to sell, so exports rise. At the same time, a weaker domestic currency makes foreign imports more expensive, so citizens buy fewer imports, and imports fall. Since the net exports equation is simply written as exports minus import, net exports must rise along with real GDP growth. Now, what about the use of contractionary monetary policy? Well, Central Banks use contractionary monetary policy to flight demand-pull inflation. That's the kind of inflation that results when aggregate demand becomes overheated. Such contractionary monetary policy, primarily involves reducing the money supply to raise interest rates. So can you now explain how higher interest rates would help fight demand-pull inflation, knowing what you know about how expansionary monetary policy does? Take a minute to jot down the reasons, GDP growth equation would be affected both directly and indirectly. When you are ready, let's move on. Okay, here's our answer. As with expansionary monetary policy, contractionary monetary policy has both direct and indirect effects. The direct effect of higher interest rates, is to reduce investment in the GDP equation. Indirect effect of higher interest rates, is to first strengthen the domestic currency. This leads to a fall in exports, a rise in imports, and a reduction in the net export driver in the GDP growth equation. So did you get the answer right? If so, that's all good. If not, you may want to go back and review the material again because from a business in investing perspective, this is all very important stuff. It's because distilled to its essence, discretionary monetary policy is all about manipulating both interest rates, and exchange rates. And these are two of the most important elements of the business and investor environment. As I will show you later in this lesson some examples. For now, however, let's just move on in our next module when you're ready, your nuts and bolts discussion of something we have talked a lot about already, but not yet properly defined, interest rates.
