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What is the role of the central bank?
A national bank that provides financial and banking services for its country's government and banking system, as well as implementing the government's monetary policy and issuing currency
What is the UK's central bank?
Bank of England
What is monetary policy used for?
Used to control the money flow of the economy. This is done with interest rates and quantitative easing.
What are the functions of a central bank?
- Manages the currency, money supply and interest rates in an economy
- Issues physical cash and using methods to prevent forgery
- Regulate bank lending to ensure stability in the financial system
How is the central bank involved in monetary policy?
The central bank takes action to influence the manipulation of interest rates, the supply of money and credit, and the exchange rate
What does is MPC?
Monetary Policy Committee
What is the role of the monetary policy committee?
In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They are independent from the government, and the nine members meet each month to discuss what the rate of interest should be. Interest rates are used to help meet the government target of price stability, since it alters the cost of borrowing and reward for saving.
What is the difference between a police objective and a policy instrument?
A policy objective is a target that the Bank of England aims to hit. A policy instrument is the tool of control used to try to achieve the objective
What is the service that the central bank provides the government with?
The central bank provides services to the Central Government. It collects payments to the governments and makes payments on behalf of the government. It maintains and operates deposit accounts of the government. The central bank also manages public debt and issues loans. The bank can also advise the government on finance, including the timing and terms of new loans.
What is the role of the MPC in monetary policy objectives?
Control of inflation has been the main objective of UK monetary policy. The government needs to control inflation in order to create conditions in which the ultimate policy objective of improved economic welfare can be attained.
How does the MPC use monetary policy instruments?
In the Uk, they can involve the Bank of England taking action to influence interest rates, the supply of money and credit, and the exchange rate
What is the bank rate?
The rate of interest the Bank of England pays to commercial banks on their deposits held at the Bank of England
What are the factors considered by the MPC when setting the bank rate?
- Unemployment rate
- Savings rate
- Consumer spending
- High commodity prices
- Exchange rate
Why is the unemployment rate considered when setting the bank rate?
if unemployment is high, consumer spending is likely to
fall. This suggests the MPC will drop interest rates to encourage more
spending.
Why is the savings rate considered when setting the bank rate?
if there is a lot of saving, consumers are not spending as much.
Interest rates might fall.
Why is consumer spending considered when setting the bank rate?
if there is a high level of spending in the economy, there
could be inflationary pressures on the price level. This would cause the MPC
to increase interest rates.
Why is high commodity prices considered when setting the bank rate?
Since the UK is a net importer of oil, a high price
could lead to cost-push inflation. This could push the MPC to increase
interest rates to overcome this inflationary pressure.
Why is the exchange rate considered when setting the bank rate?
A weak pound would cause the average price level to
increase. This makes UK exports relatively cheap, so UK exports increase.
Since imports become relatively more expensive, there would be an increase
in net exports. The MPC might consider increasing the interest rate.
What is contractionary monetary policy?
Uses higher interest rates to decrease aggregated demand and shift the AD curve to the left
Contractionary monetary policy on a diagram?
(page 431)
In the diagram, higher interest rates shift the AD curve to the left. However the extent to which the price level then falls, and/or real output falls, depends on the shape of the economy's SRAS curve. The leftward shift of AD curve causes both the price level and real output to call. This illustrates the possibility that a contractionary monetary policy, which aims to control the rate of inflation, may also cause the economy to sink into a recession. This is especially likely if the contractionary monetary policy triggers a large multiplier that shifts the AD curve further to the left.
How does an increase in interest rates decrease aggregate demand?
- Reduce household spending
- Reduce business investment
- Affect exports and imports via the exchange rate
How does a higher interest rate affect net exports?
A higher interest rate increases the demand for pounds by attracting capital flows into the currency. The increased demand for sterling causes the pounds exchange rate to rise, which makes Uk exports less price competitive in world markets and imports more competitive in UK markets. The UK's BOP on current account worsens, which shifts AD curve leftward.
How do lower interest rates affect new exports?
A fall in interest rates triggers a capital outflow in the balance of payments. The resulting increase in the supply of pounds on the foreign market leads to a fall in exchange rate. Exports become more price competitive and teh current account of the balance of payments improves. Aggregate demand increases, and the AD curve shifts rightward
What is expansionary monetary policy?
Uses lower interest rates to increases aggregate demand and shift the AD curve to there right
Expansionary monetary policy on a diagram?
Lower interest rates cause the exchange rate to fall, making exports more price competitive and imports less competitive. The AD curve shifts to they right, with the size of they shift depending on the size of the multiplier. Finally the extent to which real output increases or the price level rises depends on the shape and slope of the economy's SRAS curve, which in turn depends on the state of the economy. When the economy producers well below the normal capacity level of output, the SRAS curve is relatively flay. In these circumstances, an expansionary monetary policy is likely to increase real output, whereas increasing the steepness if the SRAS curve as normal capacity utilisation approaches means that the stimulation of real output gives way to price inflation
What is quantitative easing?
When the Bank of England buys assets, usually government bonds, with money that the Bank has created electronically
What is the hope with quantitative easing?
The hope is that financial institutions which sell the bonds to the Bank of England will then lend the newly created money to businesses and individuals. The latter can then invest and spend more, hopefully increasing growth
When was quantitative easing first used in the UK?
March 2009
In what situation is quantitative easing usually used?
Where inflation is lower and it is not possible to lower interest rates further
What happens in quantitative easing when inflation is too high?
The Bank of England can reduce the supply of money in the economy by selling their assets. This reduces the amount of spending in the economy
What is the government funding for lending schemes?
Aimed to lower costs and provide cheap funding to banks and building societies
What is forward guidance?
Attempts to send signals to financial markets, businesses and individuals, about the Bank of England's interest rate policy in the months and years ahead, so that economic agents are not surprised by a sudden and unexpected change in policy.
What is the aim of forward guidance?
To increase the credibility of monetary policy. By using forward guidance, the Bank of England aims to calm uncertainty in otherwise jittery financial markets, and also enable households and businesses to feel calmer about their future economic prospects.
Example of forward guidance?
If, for examples, markets fear that low interest rates will move higher, interest rates on bonds and other credit instruments and agreements will rise and begin to discourage people and companies from taking out loans or spending money. But if the Bank of England signals that it intends to keep rates low, the Bank hopes to engineer an outcome in which interest rates are indeed kept low
What is the relationship between changes in interest rates and the exchange rate?
A fall in UK interest rates causes financial capital to flow out of the pound and into other currencies in search of better rates of return. This reduces the demand for pounds and increases. the supply of pounds on the foreign exchange Markey, which in turn causes the pound exchange rate to fall.
What are the two ways changes in import and export prices brought by a fall in exchange rates affect inflation?
1. Falling exchange rate increase the prices of imported food and consumer goods, which increases the rate of inflation. At the same time, increases prices of imported raw materials and energy create cost push inflationary pressures in the UK
2. A falling exchange rate reduces UK export prices, while raising the price of imports. This feeds into the inflationary process described above, by increasing the demand for UK exports and persuading some UK residents to buy more home produces goods and fewer imports. This adds to demand-pull inflation pressure.
