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.

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