8.3: central banks and monetary policy

a central bank has two key functions

help government maintain macro stability, financial stability in the monetary system

the central bank manages it key functions by

managing currency, money supply and interest rates in an economy, they issue physical cash securely and use methods to prevent forgery so people trust money, central bank can regulate bank lending to ensure there is stability in the financial system

central banks act as a banker to

the government, to the banks

the central bank are a banker to the government since

it collects payments to the government and makes payments on behalf of the government, it maintains and operates deposit accounts of the government , manages public debt and issues loans, advises the government on finance including timing and terms of new loans

the central bank acts as a banker to the bank

as a lender of last resort, meaning if there is no other method to increase the supply of liquidity when low the bank of england will lend money to increase the supply

the central banks role as the banker to the government has

reduced since may 1998 as the Debt Management Office (DMO) took over responsibility for issuing treasury bills and managing the government short term cash needs

central banks create financial stability as

they act as the lender of last resort, they monitor and regulate the financial system, liasing with overseas central banks and international organisations

banks create macro stability by

controlling the note issue, acting as the governments bank, buying and selling currencies to influecnes exchange rate

monetary policy is

use of monetary instruments to control the flow of money in the economy and achieve price stability

monetary policy in the UK is conducted by

the Bank of England specifically the monetary policy committee

the bank of england’s monetary policy committee operates independently of the government to

ensure monetary decisions are made independently of political interference, this came after the events on black Wednesday 1992, and became independent upon election of labour government in 1997

black Wednesday was

a financial crisis in 1992 where the UK was forces to withdraw the pound from the European exchange rate mechanism due to it being too weak, in order to try and prevent this the prime minister John Major and the chancellor of exchequer Norman lambert agreed to use foreign currency reserves to buy up pounds to make it stronger, which didn’t work since everyone was selling

the MPCs role is

to alter base rates and therefore interest rates to control the supply of money, therefore helping to meet the government target of price stability at 2% inflation

the MPC committee is

a group consisting of 9 members who meet 8 times a year to discuss what the rate of interest should be

the base rate is

the interest rate set by central banks for lending to other banks, it is used as a benchmark for interest rates set by commercial banks

monetary policy instruments are

interest rates, quantitative easing, funding for lending, forward guidance

interest rates act as a monetary policy instrument since

it affects AD, either pushing AD up or reducing AD, therefore changing demand pull inflation

low interest rates increase consumer spending because

low interest rates reduce the opportunity cost of spending because it is cheaper for consumers to borrow from commercial banks causing less saving and more spending, households with variable rate mortgages benefit through lower repayments which increases household disposable income and increases their marginal propensity to consume, increases the number of mortgages taken out by households so demand for houses rises and since supply of houses is relative price inelastic in short term, it results in a proportionaely larger increase in house prices triggering the positive wealth effect

the positive wealth effect is

when house prices rise, people who have houses spend more money because they feel richer, boosting consumption

low interest rates impact on investment is

it means cheaper for firms to borrow from commercial banks and they use cheap loans to fund research and development or other forms of investment, since consumer spending has increased so will investment due to the accelerator effect as investment is a derived demand

low interest rates impact government spending as

it means government debt repayments will be lower, encouraging the government to issue more bonds to contribute to higher levels of government spending

low interest rates affect net trade since

interest rates affect the amount of hot money flowing into an economy, low interest rates reduces the flow of hot money into the economy, weakening the exchange rate, increasing the price competitiveness of exports as they become cheaper and causing imports to become more expensive

however interest rates may not effect net trade as

if imports become more expensive and a firm imports its raw materials then it could mean higher costs of production and therefore price, eliminating any increase in exports

hot money flows are

money flowing from different countries in search of the highest interest rates to maximise short term profits

hot money outflows weakens the exchange rate as

it increases the supply of the pound on FOREX markets since everyone is selling it or it decreases demand for the pound

LIBOR is

the London Interbank Offered Rate of interest, which is determined on a daily basis by demand and supply for funds as banks lend to each other to balance their books, it is the interest rate charged on borrowed funds by banks to other banks

quantitative easing can be used as a monetary instrument as

it helps stimulate the economy when interest rates are no longer effective i.e cannot be lowered

QE works by

the Bank of England electronically creating more money which it then uses to buy financial assets, such as government bonds, on a countries financial markets

buying bonds through quantitative easing helps encourage economic growth/increased prices

the government has the funds to spend more in the economy, for example in training and education boosting the supply side or in welfare payments increasing the disposable incomes of the poor, also if corporate/bank bonds are bought then banks will have more money and lend more to households and firms

contractionary monetary policy is done through

central banks stopping the purchase of government and bank bonds, meaning banks will hold back lending to consumers and government will delay spending on infrastructure, research and develop etc

limitations of quantitative easing are

could trigger cost push inflation, prevents productive capacity of an economy from expanding

QE can trigger cost push inflation as

the supply of money increases, the UK experiences a depreciation of its currency on FOREX markets which makes exports cheaper but imports more expensive, since the UK imports a lot of raw materials, this could trigger cost push inflation

QE can prevent the productive capacity of an economy from expanding because

it lowers long term interest rates (interest rates on bonds) because the supply of money has increase, making bonds less attractive to potential investors as the rate of return is lower, therefore less people buy government bond meaning the there is less investment in the economy by the government preventing the productive capacity from expanding

funding for lending is

a scheme that incentivises banks and building societies to boost their lending to the UK real economy, it is skewed towards small to medium sized enterprises, and focused on restarting commerical banking markets

the funding for lending scheme allows

banks and other lenders to borrow money cheaply from the Bank of England making it easier for financial institutions to provide loans at times where they would usually reduce lending

funding for lending scheme rules were changed

in January 2014 when it was no longer available for mortgage lending since it created speculative house price bubbles, particularly in london and southeast

conditions/exact data of funding for lending are

each bank or building society has access to £1 of cheap funding for every £20 of outstanding loans to companies or households, if a bank increases its lending it will have access to further rounds of cheap funding, if a bank reduces its lending it will have to pay more for funding, they are able to borrow up to 10% of their stock of existing lending

forward guidance is

used by central banks to detail what future monetary policy will be to the general public, with the intention of reducing uncertainty in markets

forward guidance aims to

increase consumer and business confidence and therefore allow investment and spending to take place, it focuses on transparency and credibility of monetary policy

the problem with forward guidance is

its credibility, due to shocks in economy banks may have to deviate from their forward guidance, reducing trust in it at all

factors that are considered by the MPC when setting the bank rate are

the unemployment rate, the savings rate, consumer spending, high commodity prices, exchange rate

unemployment rate is considered by MPC because

if unemployment is high consumer spending is likely to fall therefore they will drop interest rates to encourage spending

savings rate is consider by MPC as

if there is a lot of saving and consumers aren’t spending interest rates may fall to encourage spending

consumer spending is considered by MPC as

if consumer spending is high in the economy, there could demand pull inflationary pressure causing an increase in interest rates

high commodity prices is considered by the MPC because

since the UK is a net imported of oil high commodity prices can lead to cost push inflation, leading the MPC to increase interest rates to overcome this inflationary pressure

evaluation of monetary policy are

consumer and business confidence, currency unions, unintended consequences, trade off with unemployment, initial interest rate, overshooting, time lag, inequality

effectiveness of monetary policy depends on consumer and business confidence since

if its low there it will have less impact

currency unions impact the effectiveness of monetary policy because

its hard to set interest rates for the benefits of all countries in a monetary union like the euro

unintended consequences impacts effectiveness of monetary policy because

it can lead to government failure if it makes things worse

monetary policy has a trade off with unemployment as

tight monetary policy can potentially lower unemployment

the initial interest rate impacts effectiveness of monetary policy as

if the interest rate is already low decreases will have little impact

the effectiveness of monetary policy is reduced if it is overshot

and causes deflation, specifically malignant deflation, leading into a recession

effectiveness of monetary policy is reduced by time lag as

it takes around 18months- 2years for effects to be felt, this is because most common mortgage fix is 2 years

effectiveness of monetary policy is reduced as it can lead to inequality as

quantitative easing inflates asset prices leading to inequality for those obtaining assets, which is usually the already rich

on a graph loose monetary policy can be shown by

a shift of AD to the right, showing increase inflation, increased growth, reduced unemployment, a secondary graph of a LRAS shift can be shown since it comes as a side effect due to increased investment causing supply side shifts

tight monetary policy on a graph can be seen as

a shift in AD to the right, reducing inflation, preventing assets or credit bubbles, reducing excess debt and private saving

tight monetary policy prevents asset or credit bubbles by

reducing the money supply, decreasing demand for goods and services preventing their prices rising too high

tight monetary policy reduces excess debt and private saving by

increasing the cost of borrowing, reducing overall demand in the economy and helping to control inflation

real interest rates are

the interest rate- inflation rate

the real interest rate is crucial in

providing a clear picture of the true cost of borrowing or return on saving