Central Banks and Monetary Policy

What is a central bank?

The monetary authority and major regulatory bank of a country

Give examples of a central bank (england, europe and US)

• Bank of England

• European Central Bank

• Unites States Federal Reserve

What are the main functions of a central bank

• Setting main interest rate

• Quantitative easing

• Exchange rate intervention

• Financial stability and regulation

• issuing currency

• Lender of last resort

• Debt management

Explain the lender of last resort as a role for central banks

When other financial institutions are unable to provide loans the central bank steps in to lend money

• Emergency lending

• Discount window - provide short terms loans at slightly higher interest rate

• Collateral requirements from institutions

• Reputation - that they prevent financial panics

Give an example of a central bank as a lender of last resort

In 2012, the ECB provided emergency loans to banks in the eurozone to stabilise financial system

What is monetary policy

Changes in interest rates, supply of money & credit and exchange rates to manage economic growth

What are the main instruments of monetary policy

• Policy rates

• Asset purchases

• QE

• Forward Guidance

• Reserve requirements - liquidity standards

What is the base rate

Main interest rate set by a central bank

What is expansionary monetary policy

A central bank strategy to boost economic growth by increasing money supply and lowering borrowing costs

What are examples if expansionary monetary policies

• Fall in nominal and real interest rates

• Measures to expand supply of credit/money

• Depreciation of the exchange rate

• Leads to increase in AD

What is contractionary monetary policy

A central bank strategy to slow down an an overheating economy

What are examples of contractionary monetary policy

• Higher interest rates on loans and savings

• Tightening of credit supply

• Appreciation of exchange rate

• Reduce current account deficit (increase exports decrease imports)

Define real rate of return on saving and when do interest rates become negative

The money rate of interest minus the rate of inflation and real interest rates become negative when the nominal rate is less than inflation

Write a good chain of analysis for a change in monetary policy

1. Change in interest rates

2. Impact on aggregate demand

3. Effect on output, jobs & investment

4. Real GDP and the rate of inflation

What is Quantitative Tightening

Reduction of a central banks balance sheet by selling securities to reduce liquidity. Make gilt yields rise by increasing supply of gov bonds in the market and make borrowing costs increase

What is Quantitative Easing

The creation of new electronic money into the money supply by a central bank

What is an aim of QE

To increase the liquidity of financial institutions and an alternative strategy to cutting interest rates

Explain the process of QE

1. Central bank creates new electronic money adding more to the balance sheet

2. Money is used to buy financial assets - mainly government bonds

3. More demand leads to higher asset prices - Rise in bond prices lowers the yield on gov bonds

4. Can cause a fall in long term interest rates e.g. mortgages

5. Lower interest rates stimulate AD

What factors are considered by the mpc when setting the bank rate

• Inflation data

• Economic growth

• Employment levels

• Consumer spending

• House prices

• Exchange rates

What is forward guidance

A policy introduced in August 2013 aiming to build confidence

How did forward guidance work

• The MPC intended to maintain the highly stimulative monetary policy until economic slack had been reduced

• The Bank of England said they would leave their interest rates unchanged until the unemployment rate drops below 7% and inflation is under control.

Criticisms of the Banks policy after 2009 recession

• Inflation allowed to ride above target

• Unsustainable housing boom

• Low interest rates became less effective

• Very high current account deficit

How can a weaker exchange rate affect AD

Exports become cheaper and imports become more expensive. This means net exports (X-M) increases causing increase in aggregate demand

How can a stronger exchange rate affect AD

Exports become more expensive and imports become cheaper. This means net exports (X-M) decreases causing decrease in aggregate demand