1.8.2 Monetary Policy Flashcards
What is monetary policy?
- Use of interest rates, supply of money and credit and exchange rates to influence AD and control inflation
- Inflation target in UK is 2% +-1
What determines money supply?
- Strength of £ determined by demand and supply in forex markets
- MPC sets base rate - high street banks can set own interest rates
- Notes and coins - very small sum
- Most stores in banks electronically
- Banks make loans create electronic money
- For every £ spent in a bank another £10 is lent out to borrowers
What is expansionary/contractionary monetary policy?
Expansionary:
- Fall in interest
- Expand supply of credit
- Depreciate value of exchange rate
- Leads to rise in AD and LRAS
Deflationary:
- Higher interest rates
- Tighten credit
- Appreciation of exchange rate
- Decrease in AD
What are interest rates?
The Bank of England MPC sets the base rate of interest. This is the cost of borrowing and then return of saving - this is the interest rate for banks and then banks are able to supply their own interest rates - often smaller than interest borrowers face.
How does a change in interest affect borrowing?
- Change in market interest rates - feeds to borrowing and saving
- Impact on demand - effect on spending, saving, investment and exports as well as confidence and exchange rates - change in domestic and external demand
- Total domestic demand, exchange rates influence import prices, effect on output jobs and investment
- Real GDP and rates of inflation change
What is the process of interest rates rising?
- Market rates rise, mortgages and loans more expensive
- Assets fall in value
- More saving less spending and investment
- £ stronger against other currencies - Borrowers spend more to pay off debt, less disposable income
- Savers save more and spend less due to interest
- Demand falls
- Strong pound makes imported goods cheaper, rising deficit - Lower demand causes fall in prices of disinflation, production may increase due to lower costs
- Exports more expensive overseas
What is the process of interest rates falling?
- Market rates fall, mortgages and loans are cheaper so more disposable incomes
- Assets like houses rise in value as more want to buy
- Less saving so more borrowing and investment
- £ weaker as less attractive
- Consumer confidence increases - Borrow more money as spending less on loans
- Savers choose to save less and spend more, mpc rises
- Imports rise in price
- Higher demand in the economy
- More investment in the economy - Higher demand causes prices to rise
- Inflation rates rise
- Exports cheaper so increased exports
What is the role of a central bank?
- Monetary policy - setting interest, QE and exchange rate intervention
- Financial stability and regulation - policies designed to maintain financial stability of banks and other lenders
- Policy operation function - lender of last resort to commercial banking systems, manage liquidity levels in commercial banks
- Financial infrastructure - oversee payments used by banks
- Debt managements - handle government debt
- Issuing notes and coins
- Inflation targeting
- Banker to government and commercial banks
- Manage exchange rates
What is the role of the MPC in the UK?
Body within the BofE responsible for monetary policy and the inflation target
-Use the bank rate which commercial banks use and calculate the interest to charge borrowers. Then influences market rates, asset prices, confidence and exchange rates to change AD
- Thorough assessment of the economy each month looking at demand and supply side indicators
- Interest rate decision looked at after this
- Looks at strength of inflationary pressures and forecast
- Lots of uncertainty
- Affects demand and the supply side of the economy
- Operates free floating currency
- 2% inflation target
- Quantitative easing - £445 billion
- Capital and liquidity requirements for banks
What factors are considered when setting interest?
- GDP growth
- Spare capacity
- bank lending
- Equity markets (share prices)
- Confidence
- Growth of wages, earnings, productivity and unit labour costs
- Unemployment and employment data
- Trends in forex markets
- International data - e.g. GDP growth rates in economies of major trading partners
What is quantitative easing?
-Creates new money electronically into the national money supply used to buy government bonds or other financial assets to inject money into the economy and stimulate growth.
The MPC QE programme is £445bn of assets - mostly government bonds
- Main aim is to increase liquidity of financial institutions making it easier for them to lend.
- First introduced after 2008 to encourage lending which had stopped during the credit crunch - difficult to borrow to boost AD
What is a bond?
A bond is a method used by governments to borrow. They create an IOU which they then sell in return for cash - they promise to repay the bond at some agreed point in the future. Bonds can be bought and sold.
They are loans given to an institution issued by the government for the government to borrow. They have a fixed term and pay an annual return during the time when trading on bond markets. Demand may rise when interest rates are low or there is QE. Demand may fall when new bonds are sold offering higher coupon values
The interest rate on the bond is known as its yield which governments have to pay
What is the effect of Quantitative Easing?
- Wealth effect - rising demand for bonds leads to higher share and bond prices
- Borrowing cost effect - QE lowers interest rate on long term debt such as government bonds and mortgages making it cheaper for the government to borrow and invest
Lending effect - QE increases liquidity of banks and increased lending lifts incomes and spending in the economy
Currency effect - lower interest rates have the side effect of causing exchange rate to weaken which helps exports
What is the process of QE?
- New money electronically added
- Buys financial assets mainly bonds
- More demand leads to higher prices for assets e.g. bond prices - rise in price of bonds leads to lower yield percentage on government bonds
- Effect of QE causes fall in long term interest rates e.g. mortgages and corporate bonds
- Lower interest rates and increased cash in the banking system should then stimulate AD through a rise in consumption and investment
What is the impact of appreciation/depreciation of a currency?
Appreciation: SPICED
Depreciation: less demand for imports, more for exports
- Outward shift of AS as imports cheaper. This leads to:
- Cost pull inflation and energy and food bills higher
- Exports cheaper overseas reducing deficit and rising export sales + real GDP and jobs
- Rise in exports and fall in imports increase AD - export profits stimulus to labour market
