M13: Monetary policy

Why does the Bank of England control monetary policy?

• Expertise

• Operational independence since 1997 to prevent govts from creating short term growth for political support

What are the main functions of the central bank?

• Price stability (Target 2% ±1% CPI)

• Support govt. objectives of growth and employment

• ‘lender of last resort’

  • Readiness to loan to banks that are solvent but have short term liquidity problems to prevent another GFC

• Monitoring and regulating the financial system

What are other side functions of the central bank?

• Controlling note issue

• Acting as the bankers’/government’s bank

• Influencing exchange rate via buying and selling currency

What component of the macroeconomy do interest rates influence?

What is considered by the BoE when implementing?

• C, I and (X-M) components of AD

• Inflationary/deflationary pressures, consumer and business confidence, growth rate, employment levels

What is contractionary MP?
Eval?

Diagram?

• Increase IR to decrease AD, lowering price levels

• Extent of deflation (more realistically, disinflation) depends on the initial position of the AD curve on the LRAS

• Might trigger recession if the CMP triggers a large multiplier that shifts AD further to the left
  

What is expansionary MP?

Eval?

Diagram?

• Decrease IR to increase AD (shift right), growing national output

• Extent of real output increase to inflation depends on the initial position of the AD curve on the LRAS

• Might trigger hyperinflation if the CMP triggers a large multiplier that shifts AD further to the right

What is the transmission mechanism of MP?

What are the approximate time lags?

• 2 years for a change in IR to affect inflation

• 1% change in IR → 0.2-0.4% change in inflation after 2 years

What is Quantitative Easing?
When is it used?

• BoE buys assets (govt. bonds) with newly created money, increasing liquidity of banks

  • Banks more likely to lend loans, increasing investment, increasing AD

• When inflation is low and IR fails

QE eval?

• Inflation, potentially stagflation

  • Money supply increases, exchange rate weakens, raw materials cost more, price levels rise but output does not.

• Widens wealth inequality

  • Benefits asset owners only

What is forward guidance?

• BoE sending signals about future IR policy

  • Increases credibility, greater effects

How do IR rates affect the exchange rate and thus inflation?

• Fall in IR, Financial capital outflow, reduces demand of £ and increases supply of £, reducing exchange rate

  • Increases import prices, cost-push inflation

  • Reduces export prices, demand-pull inflation for domestic goods