Monetary Policy

What is monetary policy?

Set of actions taken by the central bank to influence level of economic activity through changes to the amount of money in circulation and the price of money

What are 4 things monetary policy is used to influence?

• Savings and bank lending

• Currency markets

• Market interest rates

• Inflation

What is the Demand for money (MD)?

The amount people wish to hold as cash as opposed to other assets

What is the supply of money (MS)?

The amount of money in circulation in the economy

What is the main tool used to change the demand for money?

Interest rates

What are interest rates essentially?

The opportunity cost of holding money

What are the axes on the MD/MS diagram?

• Interest rate

• Money holdings

What does the diagram look like?

Why is the MD curve downward sloping?

The higher the interest rate the less demand for money

Why is the MS curve perfectly inelastic?

Money supply is not influenced by market it is set by the central bank

What are the 4 functions of money?

• Medium of exchange

• Standard of deferred payment

• Store of wealth

• Measure of Value

What is narrow money?

Notes and coins in circulation - monetary base

What is broad money?

Notes and coins plus money held in bank and building society accounts

What is the term for the fact that narrow money is more easily spendable?

Liquidity

What are 3 examples of borrowing interest rates?

• Mortgages

• Credit card interest

• Interest rates on gov and corp bonds

What is the MPC?

Monetary Policy Committee

What does the MPC discuss for 2 days each month?

What interest rates should be

What are short term interest rates used to control?

Inflation

What is the ‘official rate’?

The rate at which the Bank of England will lend to the financial system and influences structure of all other interest rates

What is the inflation target set by the government?

2%

What is the real rate of return on savings?

Money rate of interest - rate of inflation

What can lead to an increase in real interest rates?

Price deflation

What type of monetary policy involves high interest rates to restrict spending?

Tight

What is another term for this type of policy?

Deflationary

What is loose/ expansionary monetary policy?

When interest rates are kept low to encourage spending

What are 3 features of expansionary monetary policy?

• Fall in real interest rates

• Measures to expand supply of credit - cost of borrowing reduces - increased spending

• Depreciation of the exchange rate - exports rise - injection - employment rises - income rises - spending increases

What are three features of deflationary monetary policy

• Higher interest rates on loans and savings

• Tightening of credit supply

• Appreciation of the exchange rate

Interest Rate Transmission Mechanism 1

What is the interest rate transmisson mechanism 1 focused on?

Loans

How does a fall in interest rates directly increase individual’s consumption?

Cost of borrowing falls

• Accessibility of credit rises

• Interest rates on loans fall

• More loans - more consumption - increased AD

How does a fall in interest rates cause increased investment?

• Interest on new loans falls

• Firms take out more loans

• Invest in capital with these loans

• I rises - AD rises - Inflation rises

What type of existing loan must firms have to be effected by a fall in the base rate?

Variable firms

How does the fall in cost of existing loans held by firms lead to increased consumption?

• Lower interest payments

• Costs reduced

• Employment/ incomes rise

• Consumption increases

Interest Rate Transmission Mechanism 2

What is the interest rate transmission mechanism 2 focused on?

Mortgages

What is property equity?

Value of house - remaining mortgage debt

What is discretionary income?

The money remaining from an individual's take-home pay after taxes and essential living expenses

What are the two ways in which a fall in interest rates effect individuals with existing mortgages causing AD to rise?

Interest rates fall - mortgage rates fall

1. Interest payments fall - increased discretionary income - consumption rises - AD rises

2. Interest payments fall - demand for housing rises - house price increases - property equity rises - wealth effect - increased consumption

How does a fall in mortgage rates cause increased investment?

• Interest rates fall - mortgage rates fall - increased demand for housing - increased profit motive for developers - increased investment by firms to supply housing

What is the interest rate transmission mechanism 3 focused on?

Exchange rates

How does a rise in interest rates cause a Balance of Payment deficit reducing AD?

• Interest rates rise - Uk bond yields and interest payments on UK savings rise - more demand for pound (needed to buy UK assets)

• Exchange rate appreciates - price of M falls and price of X rises - more demand for M - value of M exceeds value of X - BoP deficit - leakage from circular flow - AD falls

What is the most common evaluation point for the impact of interest rate changes on AD?

Time lags

What are 3 reasons why a fall in interest rates and therefore mortgage rates may not have an impact?

• Mortgage rates do not always follow base rate - banks may lose profit if they increase rate

• Many home - owners on fixed rate mortgages

• People in rented property unaffected

What are two reasons why Investment may not increase due to a fall in interest rates?

• Many loans for capital spending are on fixed rates

• Firms may have spare capacity so have no need to increase capital

Why might a fall in interest rates actually reduce consumption?

Value of savings reduces - lower confidence etc

Why might a fall in interest rates not cause inflation to rise?

Economy may have spare capacity so a rise in AD would cause no inflationary pressure

What is the liquidity trap?

When low interest rates and a high amount of cash balances in the economy fail to stimulate AD

Why does the liquidity trap occur?

If interest rates are already low there is little expected demand and so firms do not increase investment

What is the only way AD can be stimulated at this point?

Increased gov borrowing to spend directly or make tax cuts

How does a fall in interest rates redistribute income?

Income of borrowers with loans / debt rises while lenders and savers lose out

What method is used by the Bank of England to avoid a recession while in a liquidity trap?

Quantitative Easing

What is Quantitative Easing (QE)

When the central bank creates new money electronically and uses it to buy financial assets, mainly government bonds

How does QE work?

1. Central bank creates money electronically

2. Uses new money to buy gov bonds from commercial banks

3. Increased demand for bonds - bond price increases - fixed rate so interest rate (yield) falls

4. Firms can also reduce interest rate on their bonds causing banks to lower rates