Monopolistic Competition and Oligopoly

Monopolistic Competition
Definition: A market structure where firms can freely enter or exit, each producing a differentiated version of a product. Although products are close substitutes, they are not perfect substitutes, allowing each firm some degree of market power.

Characteristics:

• Differentiated products that are close, but not perfect, substitutes.
• Free entry and exit, ensuring that in the long run, economic profits tend to zero.

Short-Run Dynamics:

• Firms face a downward-sloping demand curve, granting them monopoly power over their specific product variant.
• Price (P) exceeds Marginal Cost (MC), and firms may earn positive economic profits if Price also exceeds Average Cost (AC).

Long-Run Equilibrium:

• Entry of new firms erodes profits. Eventually, P = AC, and economic profits dissipate, even though P > MC.
• The result is a deadweight loss and inefficiency compared to perfect competition, but consumers benefit from greater product variety.

Comparison with Perfect Competition:

• Perfect Competition: P = MC, no deadweight loss.
• Monopolistic Competition: P > MC, creating some inefficiency. However, the gain in product diversity partially offsets this inefficiency.

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Oligopoly

Definition: A market structure dominated by a few large firms, where entry barriers limit competition. Firms’ decisions are interdependent and strategic.

Characteristics:

• A few firms produce most or all output.
• Products may be either homogeneous or differentiated.
• Barriers to entry prevent new firms from entering easily.

Examples: Automobiles, steel, aluminum, petrochemicals, electrical equipment, computers.

Equilibrium in Oligopoly:

• Firms set prices or outputs while considering their rivals’ potential responses.
• Nash Equilibrium: Each firm chooses its best strategy given the strategies of others. No firm can profit by unilaterally changing its own decision.

Oligopoly Models:

1. Cournot Model:
   • Firms produce a homogeneous product and choose output simultaneously.
   • Each firm’s output decision depends on its rivals’ output (the reaction curve).
   • The Cournot equilibrium is reached when each firm’s output choice is optimal, given the other firms’ outputs.
2. Stackelberg Model:
   • One firm (the leader) chooses output first, and the others (followers) choose afterward.
   • The leader leverages its first-mover advantage to constrain the followers’ choices and secure higher profits.
3. Bertrand Model:
   • Firms choose prices simultaneously, assuming rivals’ prices are fixed.
   • With homogeneous products, even a slight undercut in price can capture the entire market, leading often to outcomes similar to perfect competition (P = MC).

Game Theory and Oligopoly:

• Prisoners’ Dilemma: Although all firms would be better off colluding to raise profits, each faces an incentive to undercut, leading to more competitive outcomes and lower profits.

Collusion and Price Rigidity:

• Cartels: Groups of firms that explicitly agree on prices and outputs. Cartels are more stable when demand is inelastic and the cartel controls most supply. However, most cartels fail over time due to cheating, entry, and changing market conditions.
• Price Leadership: A form of implicit collusion where one firm sets a price and others follow.
• Price Rigidity: Firms resist changing prices, fearing that any deviation may trigger a price war.

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The Goods Market in an Open Economy

Demand for Domestic Goods:
In an open economy, demand for domestic goods equals domestic demand (C + I + G) minus imports plus exports.

Increase in Domestic Demand:

• In an open economy, an increase in domestic demand raises output by less than in a closed economy because some demand spills over onto imports.
• This reduces the positive impact on domestic output and worsens the trade balance.

Increase in Foreign Demand:

• Higher foreign demand (increased exports) boosts domestic output and improves the trade balance.
• Countries may prefer waiting for foreign demand to recover from recessions rather than boosting domestic demand.

The Need for Coordination:

• In global recessions, coordination among countries can lead to collective recovery. Without it, countries may wait for others to stimulate demand.

Marshall-Lerner Condition:

• A real depreciation (a fall in the relative price of domestic goods) eventually increases net exports. In the short run, the trade balance may worsen before improving (the J-curve effect).

Equilibrium Condition in the Goods Market:

• The condition for equilibrium can also be written as: (Saving – Investment) = Trade Balance.
• A trade surplus indicates that saving exceeds investment, while a trade deficit implies that investment exceeds saving.

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Fiscal Policy

Definition: Government’s choice of taxes and spending.

Fiscal Expansion:

• Increasing government spending or cutting taxes raises the budget deficit and stimulates output in the short run.

Fiscal Contraction (Consolidation):

• Cutting government spending or increasing taxes reduces the budget deficit, aiming for long-term sustainability.

Budget Cycle:

1. Preparation: Executive branch (e.g., Department of Budget and Management).
2. Authorization: Legislative branch (Congress).
3. Execution: Executive agencies (e.g., Department of Public Works and Highways).
4. Accountability: Auditing agency (Commission on Audit).

Primary Deficit:

• Primary Deficit = Government Spending (G) – Taxes (T).
• Persistent deficits increase government debt, which eventually requires tax hikes.

Inevitable Tax Increases:

• A reduction in current taxes necessitates higher future taxes, especially if interest rates are high or the delay is long.

Debt Stabilization:

• To stabilize debt, eliminate the deficit and achieve a primary surplus equal to interest payments on existing debt.

Evolution of the Debt-to-GDP Ratio:

• Depends on interest rates, growth rates, initial debt ratio, and the primary surplus.

Ricardian Equivalence Proposition:

• In theory, larger deficits are offset by private saving, leaving demand and output unchanged.
• In practice, it rarely holds: large deficits tend to boost short-run output but reduce long-run capital accumulation and growth.

Cyclically Adjusted Deficit:

• Measures what the deficit would be under current policies if the economy were at potential output.
• Suggests running deficits during recessions and surpluses during booms.

Deficits During Wars:

• Often justified due to extreme spending needs, shifting some costs to future generations.

High Debt Ratios:

• Increase the perceived risk of default and force higher interest rates, possibly triggering a “debt explosion.”

Debt Explosion:

• A vicious cycle where growing debt and higher interest costs lead to default or money financing.

Money Finance:

• Forcing the central bank to buy government bonds with newly created money risks hyperinflation and severe economic disruption.

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Fiscal Policy 2

Budget Process and Recurrent Costs:

• Government budgets combine capital (infrastructure, development) and current (maintenance, wages) expenditures.
• In developing countries, neglecting recurrent costs can waste capital investments.

Taxation in Developing Countries:

• Heavy reliance on indirect taxes (sales, VAT, customs) due to administrative complexity in collecting income and capital gains taxes.
• Tax reform focuses on simplifying tax systems and introducing VAT for better compliance.

Tax Code Complexity:

• Complex codes increase corruption and distort the economy.
• Simpler codes reduce distortions and administrative burdens.

Progressive Taxation:

• Taxes should reflect ability to pay; however, in developing countries, effective progressive taxation is challenging.
• Measures like exempting basic goods from sales taxes help maintain equity.

Incidence of Taxes:

• Intended progressive taxes can become regressive in practice.
• Tax reforms should ensure that the burden of taxation aligns more closely with ability to pay.

Functions of Fiscal Policy:

1. Allocation: Provision of public goods and services.
2. Distribution: Influencing the distribution of income and wealth.
3. Stabilization: Achieving stable employment, stable prices, and sustained economic growth.

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Financial Development and Inflation

Money Supply:

• The stock of liquid assets in the economy. It is defined in progressively broader measures (M1, M2, M3).

Inflation as a Tax:

• Moderate inflation can raise government revenue and investment without harming growth.
• High inflation discourages holding liquid assets, hindering financial development and economic growth.

Exchange Rate Systems and Inflation:

• Under fixed exchange rates, global inflation passes directly into the domestic economy.
• Under floating exchange rates, domestic inflation is driven by local monetary conditions.

Controlling Inflation:

• Open-market operations and interest rate policies are more efficient methods of controlling inflation but are harder to implement in less developed financial systems.
• Credit ceilings and reserve requirements are second-best tools when more refined methods are unavailable.

Financial Panics:

• Despite regulatory improvements, financial crises remain possible, as seen in the late 1990s and 2007–09 episodes.

Real Interest Rate:

• The nominal interest rate adjusted for inflation. A positive real interest rate encourages holding liquid assets, promoting financial deepening and growth.

Financial Institutions:

• As economies grow, they require a range of institutions (stock and bond markets, insurance companies, development banks) to support long-term financing.

Informal Financial Markets:

• Serve those with limited resources but often charge very high interest rates.

Microfinance:

• Offers more formal, affordable credit options to underserved communities. Its overall long-term impact on poverty reduction remains debated.

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Output, Interest Rates, and Exchange Rates in an Open Economy

Determinants of Domestic Demand:

• In an open economy, domestic demand depends on both the interest rate and the exchange rate.
• Lower interest rates and currency depreciation both tend to increase domestic demand.

Interest Parity Condition:

• The domestic interest rate equals the foreign interest rate plus the expected depreciation of the domestic currency.
• This links domestic monetary conditions to external factors.

Exchange Rate Adjustments:

• An increase in the domestic interest rate typically appreciates the currency.
• A decrease in the domestic interest rate typically depreciates the currency.

Exchange Rate Regimes:

• Flexible (Floating) Exchange Rate: The value of the currency fluctuates with market conditions, giving policymakers more control over monetary policy but less exchange rate stability.
• Fixed Exchange Rate: The currency is pegged to another currency or basket of currencies. While this provides stability, it requires the domestic interest rate to match the foreign interest rate, reducing the effectiveness of independent monetary policy.

Under Fixed Exchange Rates:

• Monetary policy freedom is limited. The central bank must align interest rates with foreign rates.
• Fiscal policy becomes more effective because monetary policy must accommodate fiscal changes to maintain the fixed exchange rate.

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Monetary Policy

Definition:

• Central bank decisions on money supply and interest rates.

Monetary Expansion:

• Increasing the money supply lowers interest rates, stimulating investment and output.

Monetary Contraction (Tightening):

• Decreasing the money supply raises interest rates, cooling down inflation and reducing output growth.

Money and Its Functions:

• Money serves as a medium of exchange, unit of account, store of value, and standard of deferred payment.

Measures of Money Supply:

• M1: Currency, traveler’s checks, and checkable deposits.
• M2: M1 plus savings deposits, money market funds, and time deposits.
• M3: A broader measure including additional liquid assets.

Neutrality of Money:

• In the long run, changes in nominal money supply affect only the price level, not real output or the interest rate.

Inflation:

• Persistent increases in the general price level.
• Historically, economists focused on money growth targeting, but the weak correlation with inflation led to inflation targeting regimes.

Inflation Targeting and the Taylor Rule:

• Central banks now target a low, stable inflation rate (often around 2%).
• The Taylor Rule guides policymakers by adjusting the nominal interest rate in response to deviations in inflation and unemployment from their targets.

Natural Rate of Unemployment and the Phillips Curve:

• The natural rate is where inflation is stable.
• The Phillips Curve shows the relationship between inflation and unemployment. Initially seen as a direct trade-off, it’s now understood that only unexpected changes in inflation affect unemployment.

Optimal Rate of Inflation:

• Moderate positive inflation (around 2%) is widely considered optimal to avoid the zero lower bound and provide flexibility in monetary policy.

Unconventional Monetary Policy:

• When interest rates approach zero, central banks use quantitative easing and other tools.
• The future challenge is determining when and how to shrink central bank balance sheets and whether these tools should be standard practice.

Macroprudential Tools:

• Regulators employ measures to limit credit bubbles, control systemic risk, and ensure financial stability.
• Stable inflation alone is not sufficient for overall macroeconomic stability.

Monopolistic Competition and Oligopoly

Monopolistic Competition

• Definition: A market in which firms can enter freely, each producing its own brand or version of a differentiated product.
• Characteristics:
  1. Differentiated products that are highly substitutable for one another but not perfect substitutes.
  2. Free entry and exit.

Short Run

• The firm faces a downward-sloping demand curve and has monopoly power.
• Price (P) > Marginal Cost (MC), and the firm earns profits (P > Average Cost (AC)).

Long Run

• In equilibrium, P = AC, resulting in zero profit despite monopoly power.

Comparison with Perfect Competition

• Perfect competition: P = MC.
• Monopolistic competition: P > MC, leading to deadweight loss and inefficiency.
• Gains from product diversity offset inefficiencies.

Oligopoly

• Definition: A market in which only a few firms compete with one another, and entry by new firms is impeded.
• Characteristics:
  • Products may or may not be differentiated.
  • A few firms account for most or all total production.
  • Barriers to entry restrict new firms.
• Examples: Automobiles, steel, aluminum, petrochemicals, electrical equipment, and computers.

Equilibrium

• Firms set prices or outputs based on strategic considerations of competitors’ behavior.
• Nash Equilibrium: A strategy set where each firm maximizes profit, considering competitors’ actions.

Models in Oligopoly

1. Cournot Model:
   • Firms produce a homogeneous good.
   • Each firm treats competitors’ output as fixed and decides its production simultaneously.
   • Reaction Curve: Shows profit-maximizing output based on competitors’ output.
   • Cournot Equilibrium: Each firm correctly predicts competitors’ output and adjusts production accordingly.
2. Stackelberg Model:
   • One firm sets output first (leader), and others follow (followers).
   • The leader’s advantage is due to announcing output first, constraining followers’ choices.
3. Bertrand Model:
   • Firms produce a homogeneous good and decide prices simultaneously, treating competitors’ prices as fixed.

Game Theory in Oligopoly

• Prisoners’ Dilemma:
  • Firms prefer collusion for higher profits but face incentives to undercut each other.
  • Result: Firms often compete, leading to lower profits.

Collusion and Price Rigidity

1. Cartel:
   • Producers collude explicitly on prices and outputs.
   • Successful only if demand is inelastic and cartel controls most supply.
   • Most cartels fail due to market conditions.
2. Price Leadership:
   • A form of implicit collusion where one firm sets the price, and others follow.
3. Price Rigidity:
   • Firms resist price changes, fearing price wars, even with cost or demand shifts.

The Goods Market in an Open Economy

Demand for Domestic Goods

• Definition: In an open economy, the demand for domestic goods is equal to the domestic demand for goods (C + I + G) minus the value of imports (in terms of domestic goods), plus exports.

An Increase in Domestic Demand

• Definition: In an open economy, an increase in domestic demand leads to a smaller increase in output than it would in a closed economy because some of the additional demand falls on imports.
• Impact: This also leads to a deterioration of the trade balance.

An Increase in Foreign Demand

• Definition: An increase in foreign demand leads, as a result of increased exports, to both an increase in domestic output and an improvement in the trade balance.

Waiting for Increases in Foreign Demand

• Definition: Increases in foreign demand improve the trade balance, while increases in domestic demand worsen it. Therefore, countries may be tempted to wait for increases in foreign demand to recover from a recession.
• Note: Coordination among countries in recession can help them recover collectively.

Marshall-Lerner Condition

• Definition: A real depreciation leads to an increase in net exports.

Real Depreciation

• Definition: A decrease in the relative price of domestic goods in terms of foreign goods.
• Effects:
  • It represents an increase in the real exchange rate.
  • Initially leads to a deterioration of the trade balance and later to an improvement (known as the J-curve).

Equilibrium Condition in the Goods Market

• Definition: The equilibrium condition in the goods market can be rewritten as the condition that saving (public and private) minus investment must be equal to the trade balance.
• Implications:
  • A trade surplus corresponds to an excess of saving over investment.
  • A trade deficit corresponds to an excess of investment over saving.

Fiscal Policy

• Definition: A government’s choice of taxes and spending.

Fiscal Expansion

• Definition: An increase in government spending or a decrease in taxation, leading to an increase in the budget deficit.

Fiscal Contraction (Fiscal Consolidation)

• Definition: A policy aimed at reducing the budget deficit through a decrease in government spending or an increase in taxation.

Budget Cycle

• Stages and Responsibilities:
  • Preparation: Executive (e.g., DBM)
  • Authorization: Legislative (Congress)
  • Execution: Executive (e.g., DPWH)
  • Accountability: Commission on Audit (COA)

Primary Deficit

• Definition: The government budget constraint gives the evolution of government debt as a function of spending and taxes.
• Formula: Primary deficit = Government Spending (G) – Taxes (T)

Inevitable Increase in Taxes

• Key Points:
  • A decrease in taxes must eventually be offset by future tax increases.
  • Longer delays or higher interest rates increase the required tax hike.

Debt Stabilization

• Requirement: To stabilize debt, the government must eliminate the deficit.
• Condition: Achieving a primary surplus equal to the interest payments on existing debt.

Evolution of Debt-to-GDP Ratio

• Determinants:
  1. Interest rate
  2. Growth rate
  3. Initial debt ratio
  4. Primary surplus

Ricardian Equivalence Proposition

• Definition: Larger deficits are offset by an equal increase in private saving; deficits have no effect on demand or output, and debt does not affect capital accumulation.
• In Practice:
  • Ricardian equivalence often fails.
  • Larger deficits lead to higher demand and output in the short run but lower capital accumulation and output in the long run.

Cyclically Adjusted Deficit

• Definition: Indicates what the deficit would be under existing tax and spending rules if output were at its potential level.
• Policy Implication: Governments should run deficits during recessions and surpluses during booms.

Deficits during Wars

• Key Points:
  • Justified during high spending periods like wars.
  • Deficits shift some burden from current to future generations.

Consequences of High Debt Ratios

• Risks:
  • Increased perceived risk of default.
  • Higher interest rates leading to more debt.
  • Potential for a debt explosion.

Debt Explosion

• Definition: A vicious cycle of rising debt and interest rates that may lead to default or reliance on money finance.

Money Finance

• Definition: Issuing bonds and forcing the central bank to buy them in exchange for money.
• Risk: May lead to hyperinflation and high economic costs.

Fiscal Policy 2

Budget Process

• Recurrent Costs:
  • The government budget includes capital or development items and current use expenditures, known as recurrent costs.
  • Developing countries and donor aid programs often waste capital by neglecting recurrent costs needed for capital maintenance.

Taxation

• Indirect Taxes:
  • Developing countries primarily rely on indirect taxes (sales, value-added taxes, and customs duties).
  • Income and capital gains taxes are challenging and costly to administer, producing less revenue.
• Tax Reform:
  • Simplifies the tax system with fewer tax rates.
  • Introduces taxes like the value-added tax, which have self-enforcement properties.
• Tax Code:
  • Greater complexity increases difficulty and corruption in administration.
  • Simplified tax codes reduce economic distortions caused by taxes.

Progressive Taxation

• Definition:
  • Taxation based on an individual’s ability to pay, where higher-income individuals pay a larger share of their income in taxes.
  • A progressive tax system aligns with equity principles but is difficult to administer in developing countries.
  • Limited applications, such as exempting food from sales taxes.
• Incidence of Taxes:
  • Taxes designed to be progressive often become regressive in practice.
  • Tax reform should address this issue.

Functions of Fical Policy

Allocation Function

• Definition:
  • Provision of goods and services.
  • Provision of public goods (non-rival and non-exclusive goods).

Distribution Function

• Definition: Distribution of income and wealth.

Stabilization Function

• Definition:
  • High employment (low unemployment).
  • Price stability (moderate inflation).
  • High economic growth (high GDP growth).

Financial Development and Inflation

Money Supply

• Definition: Composed of the liquid assets of an economy. The degree of liquidity varies, leading to different, more precise definitions of the money supply.

Inflation

• Definition: Inflation is a tax on money holders. A moderate rate can increase government savings and investment without harming growth. However, high inflation shifts people away from liquid assets, undermining financial development and harming economic growth.

Exchange Rate Systems

• Definition: Essential for controlling inflation.
  • Fixed Exchange Rates: Local currency is pegged to another, such as the dollar; worldwide inflation transfers quickly to the country.
  • Floating Exchange Rates: Determined by market forces, with inflation arising from domestic sources.

Open-Market Operations

• Definition: Mechanisms like open-market operations reduce the money supply’s growth rate to control inflation. These are more efficient but less feasible in developing countries.

Credit Ceilings and Bank Reserve Requirements

• Definition: Less efficient methods but effective in curbing the growth of the money supply and inflation.

Financial Panics

• Definition: Despite progress in eliminating causes of panics, events like those in the late 1990s and 2007–09 show that financial crises can still occur.

Real Interest Rate

• Definition: The nominal interest rate adjusted for inflation. The real rate influences whether individuals are willing to hold liquid assets.

Positive Real Interest Rates

• Definition: Necessary for financial deepening (rising liquid assets to GDP ratio). Negative rates hinder this process. Financial deepening generally supports growth.

Financial Institutions

• Definition: As economies grow, they require diverse institutions for long-term financing, including stock markets, bond markets, insurance companies, and government-supported development banks.

Informal Financial Markets

• Definition: Serve small businesses and individuals with limited resources. However, loans in these markets often come with high-interest rates.

Microfinance

• Definition: Provides more formal and reasonable credit terms to underserved borrowers. Rapid expansion since the 1970s, but its overall impact on poverty remains unclear.

Output, Interest Rates, and Exchange Rates

Determinants of Domestic Demand

• Definition: In an open economy, the demand for goods depends on the interest rate and the exchange rate.
  • Interest Rate: A decrease increases the demand for goods.
  • Exchange Rate: An increase (depreciation) increases the demand for goods.

Interest Parity Condition

• Definition: The domestic interest rate equals the foreign interest rate plus the expected rate of depreciation.
  • Interest Rate: Determined by the equality of money demand and supply.
  • Exchange Rate: Determined by the interest parity condition.

Appreciation vs. Depreciation

• Appreciation: Increases in the domestic interest rate lead to a decrease in the exchange rate.
• Depreciation: Decreases in the domestic interest rate lead to an increase in the exchange rate.

Exchange Rate Regimes

1. Flexible Exchange Rate:
   • No explicit exchange rate targets.
   • Exchange rate fluctuates considerably.
2. Fixed Exchange Rate:
   • The exchange rate is maintained at a fixed level relative to some foreign currency or a basket of currencies.

Fixed Exchange Rate

• Interest Rate: Must equal the foreign interest rate under fixed exchange rates and the interest parity condition.
• Monetary Policy: The central bank loses monetary policy as a tool.
• Fiscal Policy: Becomes more effective as it triggers monetary accommodation.
  • Monetary Accommodation: A policy to stimulate economic growth by loosening the money supply.

Monetary Policy

• Definition: A central bank’s choice of the level of money supply and interest rate.
  • Monetary Expansion: An increase in the money supply, leading to a decrease in the interest rate.
  • Monetary Contraction/Tightening: A decrease in the money supply, leading to an increase in the interest rate.

Money

• Definition: A financial asset used directly to buy goods.
• Functions:
  1. Medium of exchange
  2. Unit of account
  3. Store of value
  4. Standard of deferred payment

Money Supply

• M1: Currency, traveler’s checks, checkable deposits (narrow money).
• M2: M1 plus money market mutual fund shares, savings deposits, time deposits (broad money).
• M3: Broader than M2, constructed by the central bank.

Neutrality of Money

• Definition: The proposition that an increase in nominal money only affects the price level, with no impact on output or the interest rate.

Inflation

• Definition: A sustained rise in the general level of prices.
• Inflation Rate: The rate at which the price level increases over time.

Inflation and Nominal Money Growth

• Early focus on nominal money growth was abandoned due to its weak relationship with inflation.

Inflation Targeting

• Definition: Central banks now target the inflation rate rather than nominal money growth.

Taylor Rule

• Definition: A guideline for setting the nominal interest rate based on:
  1. The deviation of the inflation rate from the target.
  2. The deviation of unemployment from the natural rate.
• Purpose: Stabilizes economic activity and achieves medium-run inflation targets.

Natural Rate of Unemployment

• Definition: The unemployment rate at which inflation remains constant.
  • Above natural rate: Inflation decreases.
  • Below natural rate: Inflation increases.

Phillips Curve

• Definition: Plots the relationship between inflation and unemployment.
  • Original: Relation between inflation rate and unemployment rate.
  • Modified: Relation between the change in inflation rate and unemployment rate.

Optimal Rate of Inflation

• Definition: Balances the costs and benefits of inflation.
  • Optimal rate often considered around 2% (e.g., targets by UK, ECB, US Federal Reserve).

Unconventional Monetary Policy

• Definition: Used when economies hit the zero lower bound (e.g., quantitative easing).
  • Central bank purchases affect risk premiums and increase balance sheets.
  • Future challenge: Whether to reduce central bank balance sheets and use these measures in normal times.

Macroprudential Tools

Optimal use remains a challenge for monetary policy.

Definition: Used to limit bubbles, control credit growth, and decrease financial system risk.

Stable inflation is insufficient for macroeconomic stability.