3.2.4.1 MONETARY POLICY

Define central bank

A national bank provides financial and banking services for its countries's government and banking system, as well as implementing the government's monetary policy and issuing currency. The bank of England is the UK central bank

Bullet point what the definition is of the central bank?

• a banks bank

• the lender of last resort

• oversees the financial markets

• ensures price stability

• promotes the 4 main macroeconomic objectives set by the government

Explain the main functions of a central bank

The inflation target (set at 2%), macroeconomic stability and supporting the 4 main government macroeconomic objectives

What are the 4 main government macroeconomic objectives?

1. Economic growth

2. Low/stable inflation

3. Low unemployment

4. A stable balance of payments

What is the Bank of England's target for inflation?

2% + or - 1%

What is meant by macroeconomic stability?

Air condition of low validity in key, economic indicators, including stable prices, consistent economic growth, low unemployment, and a sustainable balance of payments

What does macroeconomic stability indicate?

An economy's ability to avoid extreme erratic, disruptions, providing a predictable environment for investment and growth

What is a policy objective?

The desired, specific outcome or goal a government aims to achieve

Examples of policy objectives

Reducing carbon emissions

What is a policy instrument?

The tool used to implement that policy and achieve the goal

Examples of policy instruments

• interest rates

• exchange rates

• money supply

• buy/sell currency

How do people buy and sell currency?

FOREX

What is FOREX?

The foreign exchange market (global market for currency)

Is taxation part of monetary of fiscal policy?

Fiscal

Define interest rate

An interest rate is the cost of borrowing money or the reward for saving it

What is the interest for loans?

APR

What is the interest for savings?

AER

What are the 2 types of exchange rates?

• floating exchange rate (appreciate/depreicate)

• fixed exchange rate (devalue/revalue)

What is the current interest rate?

3.75%

What are the 2 types of interest?

Simple or compound

What is the Bank of England’s link to commercial banks?

It is the parent banks to commercial banks

What is the current CPI (inflation) rate?

2.9%

What is the platform called where people buy and exchange currency? When do you access it?

FOREX (access it 24/7)

What are 7 policy instruments used by the Bank of England?

1. Base rate of interest

2. Controls the money supply

3. Buying and selling currency

4. The lender of last resort

5. Commercial banks have a bank account with the Bank of England, so does the government

6. Quantitative Easing

7. Buying government bonds (gilts)

   
   

What is conventional monetary policy?

The normal everyday tools used in typical economic conditions

What is unconventional monetary policy?

Tools used in crisis or when interest rate rates are already very low and can't cut much further

Examples of conventional monetary policy instruments?

• base rate of interest

• buying and selling government bonds

• controlling the money

Examples of unconventional monetary policy instruments?

• quantitative easing

• buying gilts

What is an OLD examples of unconventional monetary policy?

Forward guidance - giving businesses a heads up about interest rates

Why did forward guidance not work?

Had little impact on businesses as they were already not confident - so it was binned off

Who is in charge of the Bank of England? What is his role?

Andrew Bailey - governor

Who did the Bank of England become independent from?

The government

When did the Bank of England become independent, and who was prime minister?

1997, Tony Blair

Before 1997, who decided interest rates?

The government

Why did the Bank of England become independent?

• reduced political influence

• controls inflation more effectively

• increases confidence

• improves long term economic stability

Why would interest rates have a political influence when sat by the government?

Before, interest rates could be reduced to sway elections

Who is seeing more credible, the Bank of England or the government? Why?

The Bank of England - financial markets trust decisions made by experts rather than politicians

How many people are in charge at the Bank of England?

A committee of 9

• governor - Andrew Bailey

• some representative of government

• some representative of business

What is the role of monetary policy?

To control the economys overall level of demand in order to keep it stable

Who sets the inflation target? And who tries to meet it?

The government sets the target of 2% +/- 1% and the Bank of England tries to meet it

What are 5 things that monetary policy controls?

1. Controls inflation

2. Stabilize economic growth

3. Influence AD

4. Support employment

5. Maintain financial stability

What is the AD equation?

AD = C + I + G + (X-M)

What does each letter stand for?

C - consumption (spending by households)

I - investment (spending by firms)

G - government spending (public services, infrastructure)

Which letter does monetary policy not affect?

G - government spending

Is monetary policy a supply side policy?

No

Define "contractionary" monetary policy?

When the Bank of England takes action to reduce the money supply and decrease aggregate demand in the economy

• used to slowdown an “overheating” economy

What does the graph look like for "contractionary" monetary policy?

At what point in the economic cycle, does demsnd deficient demsnd occur?

• a downturn

• a recession (depression)

  
  

What does deficient demand lead to?(Link to the economic cycle)

A negative output gap

Define exchange rate

The price of one countries currency in terms of another countries currency, essentially it tells you how much of one currency you can buy with one unit of another

Does monetary policy shift the AD curve or the AS curve?

AD curve

Explain how an increase in the interest rate decreases AD?

• higher interest rate rates reduces household consumption

• increases the cost of borrowing

• increased incentive to save

• reduces both business and consumer confidence

• exports become more expensive

• imports become cheaper

• decreased AD

When demand decreases, what happen to

• the curve

• Real GDP

• prices

• shifts AD curve inwards

• reduced real GDP

• decreases prices

Give an example of a strong pound?

£1 = $3

What does SPICED mean? (In terms of a strong pound)

Strong

Pound

Imports

Cheaper

Exports

Dear

Define " expansionary" monetary policy?

A set of tools used by central banks to stimulate the economy, it's primary goal is to increase AD

What does the graph look like for "expansionary" monetary policy?

Write a logical chain of reasoning of expansionary monetary policy, and how it leads to a shift outwards of the AD curve?

• Bank of England reduces the interest rate

• lower cost of borrowing

• boots consumption, investment and net exports

• the multiplier effect

• shift in the AD curve

What does the multiplier effect mean?

The injection of spending does not stop at the first transaction

• firms receive more orders

• hire more workers

• more wages

• workers spend their income

Explain the transmission mechanism

A process by which essential banks initial policy decision (like changing the interest rates) moves through different channels to influence AD and inflation

Give the steps of the transition mechanism

1. Central banks change interest rates

2. Market inters rate and exchange rate changes

3. These changes influence spending saving and investment decisions of households and firms

4. AD shifts

5. Affects domestic prices and inflation

What are some impacts of timelags on the transition mechanism?

• forecasting difficulty

• risk of over correction

How do commercial banks respond to the Bank of England’s interest rate?

The commercial bank rate have to be within a range of the BoE’s interest rate

What is money called in terms of exchange rates?

Hot money

What is hot money?

When a foreigner exchanges their currency for £ by saving in the UK banks - more money flowing into the UK

Give the process of what happens if the Bank of England increases its interest rate?

• interest rate is increased

• commercial banks increase their interest rates

• asset prices decrease

• decreased “animal spirits” - spend more in the future, not now

• foreigners invested into the country as there is a better/higher interest rate

• strength of the pound increases

• unhappy British businesses (to sell their products) - domestic demand decreases

• net exports will worsen (cheaper imports)

• AD decreases (decreases in cost push and demand pull inflation)

Give an example of s weak pound and a strong pound?

£1 = $1.50 - weak pound

£1 = $2.00 - strong pound

What are the 2 words for remembering for how strong/weak pounds affects imports and exports?

SPICED

WPIDEC

What is quantitative easing?

A monetary policy tool where a central bank creates digital money to buy financial assets, such as government bonds and gilts

Describe the process of QE?

• this injects lots of cash into the banking system

• as there is higher demand for bonds, their “yield” (interest rate) drops

• this makes borrowing cheaper

• people spend more

• shifts AD outwards/to the right

What is forward guidance?

A communication tool where central bank tells the public it's likely future path for interest rates could

What does forward guidance aim to influence?

The financial decisions of households and businesses today by reducing uncertainty about tomorrow

How has forward guidance been positive?

Helps boost confidence and manage expectations

How has forward guidance been negative?

If the Bank of England breaks its promise, it loses public trust, major global event events/shocks (2022 + 2026 - oil crisis) makes it difficult, can reduce confidence if Bank of England predicts high interest rates