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Chapter 26: Problem 5

In explaining why monetary policy did not pull Japan out of a recession in the early \(2000 \mathrm{~s}\), an official at the Bank of Japan was quoted as saying that despite "major increases in the money supply," the money "stay[ed] in banks." Explain what the official means by saying that the money stayed in banks. Why would that be a problem? Where does the money go if an expansionary monetary policy is successful?

Short Answer

Expert verified
The Bank of Japan official means that despite the bank's efforts to stimulate the economy through an expansionary monetary policy (i.e., increasing money supply), commercial banks refrained from lending the extra money out, but instead kept it within their reserves. This represents an issue because for the expansionary monetary policy to work, the additional money should flow into the economy via loans to businesses and consumers. In a successful scenario, the expansionary monetary policy would boost borrowing, leading to increased investment and spending, therefore stimulating economic growth.

Step by step solution

01

Understanding Monetary Policy

Monetary policy is a tool used by central banks to control the money supply with the aim of promoting economic growth and minimizing economic downturns. The major way central banks achieve this is by buying or selling government bonds. When a central bank, such as the Bank of Japan, wants to increase the money supply, it purchases government bonds from banks, thus giving these banks more money. This is called expansionary monetary policy.
02

Explaining 'Money Stayed in Banks'

By stating that the money stayed in banks, the official is implying that after the Bank of Japan increased the money supply by purchasing government bonds, commercial banks chose not to loan out the additional funds. Instead, they kept the money within their reserves.
03

The Problem with Money Staying in Banks

For an expansionary monetary policy to stimulate economic growth, it is crucial for the increased money supply to circulate in the economy. This is typically achieved when banks lend out more money to businesses and consumers. If banks choose not to lend and keep the money, it limits the circulation of money in the economy, thus making it impossible for the policy to stimulate economic growth or pull Japan out of recession.
04

Successful Expansionary Monetary Policy Outcome

Under a successful expansionary monetary policy scenario, an increase in money supply should lead to more loans for businesses and consumers. This subsequently results in increased investing and spending, which in turn stimulates the economy, driving it out of a recession.

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