Monetary Policy

What is monetary policy?

• Demand side policy

• Management of interest rates + money supply

What are the two types of interest rates?

• Normal interest rates - unadjusted for inflation

• Real interest rates - adjust for inflation

What is the government target for monetary policy?

Keep CPI (Consumer Price Index) inflation at 2 ± 1%

Who sets the base interest rate in the UK?

The Monetary Policy Committee in the Bank of England

What is the transmission mechanism of monetary policy?

1. Base rate increases → market rates increases / asset prices decrease / confidence decreases → domestic + external demand decreases → domestic inflationary pressure decreases → inflation decreases

2. Base rate increases → foreign businesses/consumer move money into banks (hot money) → increased demand for £ → inflation decreases

What are the two advantages of expansionary monetary policy?

• Increased economic growth

• Decreased unemployment

What are the two disadvantages of expansionary monetary policy?

• Inflation

• Worsens BoP

What is the process of quantitative easing?

1. The central bank creates digital money

2. They buy back previously issues gov bonds (IOU bought by commercial banks/businesses/individuals who get coupons)

3. Commercial banks/businesses/individuals have more money

4. Banks decrease interest rates

5. Increased borrowing → increased consumption