4.3 Central Banks and monetary policy

the main functions of a central bank

1) Implementation of monetary policy

2) Banker to the government

3) Banker to the banks

4) Regulate the financial system

explain monetary policy as a function of central banks

Central banks use monetary policy including QE and changing intrest rates to control the level of inflation in the economy with the goal of keeping inflation low and stable at the 2% target

explain banker to the government as a function of central banks

manages the governments browing (T Bills and Bonds) and debt

manages the governments bank acounts

explain the banker to banks as a funtion of central banks

Lender of last resort

banks for comercial banks

Explain the significance of “Lender of last resort“

the central banks act as a lender of last resort in the case that banks face liquidity problems (eg in a bank run or financial crisis). They provide short term loans to pevent systemic financial instability and maintain confidence in the banking system

Explain regulating the financial system as a function of a central bank

Macro and micro prudential regukation is done by the central bank

when is there rational for regulation if

public intrest is harmed or at risk

what does monetary polidy include

Intrest rates

supply of money and credit

exchange rate

monetary policy

The use of intrest rates, supply of money and credit and exchange rate to influence the economy and help the government achieve its objectives

primary monetary policy objective set by the government

acheive low and stable inflation with inflation at 2%

bank rate

the intrest rate paid to comercial banks on thier money held at the BoE

how does increasing the bank rate lead to lower inflation

increasing bank rate → the interest rates paid to commercial banks for saving increases → banks increase their interest rates to maintain profit margins → increased costs of borrowing

for consumers

→ reward for saving increases → more incentive to save → saving is a withdrawal from the circular flow of income

→ cost of borrowing increases → Consumers are more likely to delay spending on big-ticket items → consumers with variable rate mortgages → higher living costs → less consumption

for firms

→ increased borrowing costs → higher costs of production depending on debt to equity ratio → lower revenue as consumers are spending less (unless inferior goods) → lower profits -> less investment

whole economy

lower consumption, lower investment, increased saving → AD shifts in → price level falls → lower inflation

global economy

→ more hot money inflows → exchange rate appreciates → cost of imported raw materials falls → lower cost-push inflation

evaluative points for if increasing bank rate does lower inflation

if consumers have high inflation expectartions → increase immediate consumption irrespective of higher intrest rates as they are worried that goods will just become more expensive

consumers costs of living are only u=impacted if they have loans or variable rate mortages, those with high levels of savings may increase consumption

firms may not experience less investment → could raise equity or have wealthy owners or may be making more revenue if producing inferior goods

negative impacts → lower econ growth, cost of living crisis, increased wealth inequality, high unemployment, trade deficit

could worsen cost push inflation → if higher borrowing costs are passed onto consumers → policy is more effective if the cause is demand pull

how does reducing the bank rate lead to higher inflation

lower bank rate → cost of borrowing for comercial banks falls → comercial banks lower

evaluate reducing intrest rates to increase inflation

if confidence is low → consumers and firms may be unwilling to borrow to invest even if the cost of borrowing is lowered

there is a zero lower bound on interest rates → if they are already low they can’t be lowered further

if consumers expect interest rates to be reduced even further → may not be more immediate consumption → MPC can use forward guidance to prevent this

time lags → The transmission mechanism will take time to work and lower increasing inflation

which country had negative intrest rates

Japan for 17 years

role of the MPC

meets 8 times a year to review the economic conditions and set the bank rate

monetary policy instruments

Bank rate

Quantitative easing

Forward guidance

forward guidance

when the central bank provides information about the likley future course of monetary policy

two main responsibilities of the central bank

maintain financial stability and help the government acheive macroeconomic stability

monetary policy transmision mechanism

Ways in which monetary policy affects aggregate demand, economic activity, inflation and the other objectives of government macroeconomic policy

how do higher intrest rates cause higher echange rate

higher intrest rate → increases reward for saving in UK banks → increased hot money inflows → more demand for pounds → currency appreciates

how does a higher exchange rate impact inflation

higher exchange rate → imports are cheaper → imported raw materials are cheaper → lower costs of production → SRAS shifts down → lower cost push inflation

exports are more expensive → improts are cheaper → trade deficit worsens → AD shifts inwards → lower demand pull inflation

what factors do the MPC consider when setting intrest rates

inflation, economic growth, debt, savings, unemployment, house prices and wages

how does lowering intrest rates lead to a positive wealth effect

mortgages/bowworing costs are lower → demand for homes/other assets increases → value of homes/other assets rises → increased confidence/animal spirits → increased consumer spending

evaluate decreasing IR → positive wealth effect

large amounts of the population don’t own wealth (15% have no or negative wealth) → no/limited wealth effect → worsening wealth inequality

how does the bank of england influence the money supply

by changing the bank rate or via quantitative easing

how does lowering the intrest rate increase the money supply

lower intrest rates → more borrowing and less saving → more money in circulation

Money supply

measures the total amount of money in circulation in an economy

explain how QE works

central banks create electronic money → purchase government bonds from comercial banks and pension funds → liquidity of comercial banks increase → banks lend more as high liquidity is unprofitable → increased borrowing → increased money supply → increased consumption → shifts AD out → economic growth and inflation

→ demand for bonds increases → bond price increases → bond yeild falls → lower market intrest rates for firms → lower borrowing costs → increased investment

why may QE not increase money supply

if confidence is low → as is likley in a recessionary period → comercial banks may be unwilling to lend and the consumers/businesses wanting to borrow may be high risk → credit crunch→ banks just save the money and do not lend → no change in the money supply/inflation/econ growth

consumers and businesses may also be unwilling to borrow no matter how low interest rates are → low confidence and high uncertinaty

How does quantitative tightening work

central banks sell assets purchased during a period of QE → banks have lower liquidity → less borrowing

supply of bonds increases → bond price decreases → bond yeild increases → firms have to offer higher yeilds on corporate bonds → less borrowing

when is QE used

as an extreeme measure when intrest rates can’t be lowered further or are no longer effective at stimulating the economy, likley in periods of economic stagnation or after a financial crisis

when was QE first used in uk

In 2009 to stimulate the economy after the economic crisis when inflation rates were near 0

why do intrest rates have a zero lower bound

practical reasons → many of the computational systems that banks are run on were programed along time ago → concerns they may crash if IR were negative

if savers are charged for saving and their money erodes in value → consumers will keep cash instead → banks will have no funds for lending → liquidity trap

funding for lending

when central banks give funding to comercial banks at preferential rates to encourage banks to lend more

How can the bank of ingland influence the money supply

1) Intrest rates

2) QE or QT

3) forward guidance

liquidity trap

when monetary policy becomes ineffective because intrest rates are already low and people prefer to save instead of spending or investing

what happens in a liquidity trap

• intrest rates are low and the central bank cannot stimulate the economy by lowering them further

• demand for money becomes perfectly elastic → hoard money instead of spending or investing

• business and consumers are unwiling to borrow due to low confidence and uncertinaty

• firms deleverage

what is deleveraging

when firms reduce thier level of debt