4.2.4.3 - Central Banks and Monetary Policy

Central Bank

A national bank that oversees the country's banking system and provides financial services to the government and commercial banks.

- It is a banker to the government, and a banker to banks

UK's Central Bank

Bank of England

(monetary policy in UK has been delegated to Bank of England)

Functions of a Central Bank

My Schools Regulation Policy Department

Monetary, Stability, Regulatory, Policy, Debt
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MONETARY POLICY:

- Setting interest rate (bank rate)

- Quantitative Easing (money supply)

- Exchange rate intervention

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FINANCIAL STABILITY & REGULATORY FUNCTION:

- Supervision of the wider financial system

- Prudential policies to maintain financial stability

- Financial Policy Committee (FPC), Prudential Regulation Authority (PRA), Financial Conduct AUthority (FCA)

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POLICY OPERATION FUNCTIONS:

- Lender of last resort to banking system

- Managing liquidity in commercial banking system

- Overseeing the payments system used by banks/retailers/credit card companies

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DEBT MANAGEMENT:

- Handling the issue and redemption of issues of government debt (government bonds)

Monetary Policy

The use (by Central Bank) of Interest Rate, Money Supply and Exchange Rate to influence the level of economic activity and achieve macroeconomic stability.

Interest Rate

The reward for saving and the cost of borrowing (%)

Money Supply

The total amount of monetary assets (cash, coins, and balances held in bank accounts) available in an economy at a specific point in time.

Exchange Rate

The value of one currency relative to another currency.

Objectives of Monetary Policy (targets for BoE to meet)

Main Objective: Price Stability - meet inflation target of 2% ± 1%

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Other objectives: Achieve full employment and achieve steady sustainable economic growth. (these are typically only pursued if they do not conflict with inflation target)

Bank Rate

The interest rate set by the Bank of Engand which it uses as a benchmark for setting the interest rates that it charges when lending to commercial banks & other financial institutions.

Conventional Monetary Policy

BoE using Bank/Interest Rate to manage the level of AD to control inflation

Unconvential Monetary Policy

Use of other interventions apart from interest rates. Includes Quantitative Easing, Forward Guidance, Funding for Lending.

Why did the UK have to resort to Unconventional Monetary Policy following the 2007-2008 GFC?

Because Bank Rate was already 0.5% so traditional monetary policy was ineffective as stimulating AD

What is the Monetary Policy Committee (MPC)?

The MPC is part of the Bank of England that is in charge of monetary policy, specifically setting interest rates.

‎Its aim is to achieve monetary policy objectives like the government’s target rate of inflation through changing Bank Rate.

How many members are on the Monetary Policy Committee (MPC)

9 economists, chaired by the governor of the Bank of England

How long can it take for a change in interest rates to have the maximum impact (full effect) on inflation?

About two years.

Hence, setting of interest rates is pre-emptive (forward-looking to 18-24 months)

Contractionary/Tight Monetary Policy

Used to restrict AD

• High Interest Rates

• Restricted Money Supply

• Strong Exchange Rate

Expansionary/Loose Monetary Policy

Used to increase AD

• Low Interest Rates

• Increased Money Supply

• Weak Exchange Rate

Monetary Policy Transmission Mechanism =

The process by which a central bank’s monetary policy decisions are passed on through financial markets, to businesses and households, affecting economic activity & inflation through several channels.

Monetary Policy Transmission Mechanism Chain of Analyses

Bank Rate↓…:
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Consumption (individuals & households):

—> Commercial Rate‎↓ —> Incentive to save ↓ —> Saving ↓ —> C↑ —> AD↑ —> D-pull Inf

—> Commercial Rate↓ —> Cost of new borrowing ↓ —> C↑ —> AD↑ —> D-pull Inf

—> Commercial Rate↓ —> Cost of existing borrowing ↓ —> Real disposable income ↑ —> C↑ —> AD↑ —> D-pull Inf
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Investment (firms):
—> Commercial Rate‎↓ —> Incentive to save ↓ —> Saving ↓ —> I↑ —> AD↑ —> D-pull Inf

—> Commercial Rate↓ —> Cost of new borrowing ↓ —> Borrowing ↑ —> I↑ —> AD↑ —> D-pull Inf

—> Commercial Rate↓ —> Cost of existing borrowing ↓ —> Retained Profits↑ —> I↑ —> AD↑ —> D-pull Inf

C↑ —> Spare capacity ↓ —> I↑ —> AD↑ —> D-pull Inf

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Net Exports (exchange rate):
—> Commercial Rate ‎↓ —> Hot money outflows —> Demand for £ ‎↓ —> Price of £ ‎↓ (depreciation) —> Exports cheaper & imports more expensive —> X↑ & M‎↓ —> Net exports ↓ —> AD↑ —> D-pull Inf

—> Commercial Rate ‎↓ —> Hot money outflows —> Demand for £ ‎↓ —> Price of £ ‎↓ (depreciation) —> Imports more expensive —> CoP↑ —> SRAS left —> Cost-push inflation —> AD contracts

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Asset Prices:
—> Commercial Rate ↓ —> % yield on saving ↓ —> People seek alternative asset classes with higher yield/returns (e.g. bonds, shares) —> Demand for alternative assets ↑ —> Asset prices ↑ —> People feel more wealthy —> C↑ I↑ —> AD ↑ —> D-pull Inf

—> Commercial Rate ↓ —> Cost of borrowing ↓ —> Cheaper to take loans —> Cheaper to buy assets —> Asset prices ↑ —> People feel more wealthy —> C↑ I↑ —> AD ↑ —> D-pull Inf

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Expectations/Confidence:

IR ↓ —> People expect EG —> Confidence in job security & in the economy —> C↑ I↑ —> AD ↑ —> D-pull Inf‎

Real-world application of cut in interest rates on exports (China)

China devalued their currency to be more interntionally price competitive to increase exports

Factors considered by the MPC when setting the Bank Rate

Demand-side Factors:

• Financial Markets & House Prices - Higher FM & HP in future —> Higher wealth —> Higher C & I —> AD ↑ —> overheating D-pull inf —> IR ↑

• GDP Growth & Spare Capacity - Higher GDP/Narrowing NOG —> Risk of overheating D-pull inf —> IR ↑

• Consumer Spending - Spending & Confidence forecast to increase —> High AD —> Overheating D-pull inf —> IR ↑

• Money & Credit - High money supply & credit available and being used —> High C & I —> Overheating d-pull inf —> IR ↑

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Supply-side Factors:

• Labour Market - U/E falling / Labour Shortages —> Strong Wage Growth —> Overheating Cost-push inf —> IR ‎↑

• Costs & Prices - High CoP (scarcity) & High import commodity prices —> Cost-push inf —> IR ↑ to strengthen the £

• Business Confidence - Survey results indicate High business confidence —> High Investment —> Increase PP —> SRAS & LRAS right —> Reduction in Cost-push inf in long-run

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International Factors:

• Exchange Rate - Forecast depreciating £ —> Price of Imports ‎↑ —> CoP ‎↑ —> Cost-push inf —> IR ‎↑ to strengthen £

• Macroeconomic Developments Globally - Forecast inflation to be high abroad —> Higher cost-push inf —> IR ↑ to strengthen £

Why is it hard to forecast inflation?

• Need to forecast events in future (up to 2 years in advance) because interest rate changes take up to 24 months to have full effect in economy

• Accuracy of data may have errors + difficult to obtain data

• Difficult to anticipate external shocks

• IR changes will have varying effects depending on the economy’s confidence & whether banks willing to lend

• Need to factor in other PUBE objectives (conflicts)

Factors impacting the Effectiveness of Interest Rates

SCUMCOT

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Size of Interest Rate Change - affects impact

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Confidence - Level of business & consumer confidence

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Unexpected Shocks

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Multiplier - Depends on size of multiplier

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Ceteris Paribus - other changes

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Output gap size - starting point of economy - if large nog, inflation is due to cost-push factors so IR won’t help

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Time Lag - Takes up to 2 years for full effect, as commercial banks take time to adjust IR to reflect change in Bank Rate

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Time Duration - Depends on how long IR change is implemented for

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Rate Change Pass On - Rate change is made by BoE on Bank Rate it lends to commercial banks - they may not pass it on

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Borrowing Type & Level - IR changes won’t impact fixed loans/mortgages in short-run

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Cause of Inflation - If inflation caused by supply-side factors (cost-push inf) then will be less effective; If inflation driven by expectations then will be ineffective

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Other countries interest rates - affects hot money inflow/outflows

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Price Elasticity of Imports & Exports

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Objective Conflict with Unemployment & EG - Low inflation conflicts with u/e & eg

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Objective Conflict with BoP - low inflation conflicts

Advantages of Interest Rate Monetary Policy

• Flexible & Quick to implement (can be changed monthly)

• MPC is Independent - no political interference, transparent & accountable

• MPC has good track record since 1997 of using IR

• Strong transmission effect working through ¾ AD components (C, I, X-M)

• No crowding out effect

• Doesn’t cost much (compared to fiscal)

• Works both ways - avoid inflation & avoid deflation

Disadvantages of Interest Rate Monetary Policy

• Potential for LIQUIDITY TRAP

• Blunt instrument - many side effects (asset price bubbles) & cannot be tailored to specific regions & industries

• Time lag (up to 2 years)

• Works primarily on AD - not as effective on supply-side (cost-push)

• PUBE conflicts

• Zero-bound - Cannot lower IR below nominal 0%

What is the Liquidity Trap?

When low interest rates and high cash balances in the economy fail to stimulate aggregate demand.

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This is due to 2 factors:

Low Confidence (business & consumers)

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Blocked Credit Channel - Credit Crunch, banks not lending

How was the Global Financial Crisis an example of the Liquidity Trap?

Low Confidence:

• Confidence of individuals, households & firms regarding future economic prospects were low —> C & I did not rise significantly in response to BoE cutting interest rates (from 5% to 0.5%) —> AD didn’t rise significantly

• Individuals, households & firms saved more than consuming & investing —> Increasing ‘withdrawals’ from circular flow of income —> Reducing size of positive multiplier

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Blocked Credit Channel:

• Cut in bank rate provided little stimulus because banks had become ‘frozen’ - they were not lending to one another or to individuals, households & firms for fear of not getting a return on their lending (i.e. a credit crunch) -- banks become highly ‘illiquid’ —> Fewer loans —> Lending did not increase —> C & I didn’t increase —> AD didn’t increase

How does a Depreciation of a Currency impact Various Macroeconomic Objectives?

Impact on…:

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Economic Growth: Depreciation —>

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Unemployment:

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BoP:
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Demand-pull Inflation

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Cost-push Inflation:

Quantitative Easing (def + chain of analysis)

= Unconventional monetary policy where a Central Bank creates new money electronically, used to buy financial assets such as government bonds. (used when traditional monetary policy is ineffective)

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Sharp fall in AD —> SREG↓ + Inf ↓ —> BoE electronically creates money —> Uses it to purchase assets (mainly gov bonds) —> Demand for gov bonds ↑ —> Price of gov bonds ↑ —> Yield of gov bonds ↓ —> Demand for shares of corporate bonds ↑ —> Yield ↓ —> Cost of Borrowing ↓ —> C↑ I↑ —> AD ↑

What is the effect of Quantitative Easing on Bond Prices & Long-term Interest Rates?

Bond Prices ↑

Long-term Interest Rates ↓

How has the UK used Quantitative Easing

• The BoE first introduced QE in March 2009 in response to the global financial crisis (07-08)

• This is when bank rate had already been reduced to 0.5%, so could not be reduced further

• Traditional monetary policy had become ineffective at simulating demand

• Initially, BoE purchased £75 billion gov bonds

• By 2021, £895 billion of QE has occured in UK in response to further economic shocks, like Eurozone crisis, Brexit uncertainty, COVID-19 Pandemic

Funding for Lending Scheme

• = Incentivises banks and building societies to boost their lending to the UK real economy. (stimulating AD)

• It allows commercial banks to swap assets (low quality) for treasury bills (high quality)

• Commercial banks use Treasury Bills as ‘collateral’ to borrow money cheaply

• Commercial banks can offer lower interest rates on loans —> C↑ I↑ —> AD↑

also

• Commercial banks offer lower interest rates for savers as don’t need to work so hard to attract new funds —> Reduced incentive to save —> C↑ —> AD↑

also

• Increased I↑ —> Increased LRAS

• Lower cost of borrowing for firms —> SRAS right —> SREG

When was the Funding for Lending Scheme introduced in the UK to recover from the GFC

July 12th 2012

Forward Guidance

Attempts to send signals to financial markets, businesses and individuals about the future interest rate policy, so that economic agents are not surprised by unexpected changes.

• Increases credibility of monetary policy

• Decreases uncertainty

Example of Forward Guidance in practice

In August 2013, Mark Carney said that the bank would not consider raising Bank Rate from its low of 0.5% until the unemployment rate fell to 7% or below.