2) Interest rates as monetary policy - MMT Flashcards
Why do commercial banks exist?
To maximise profits
What does changing the base rate have a knock-on effect on?
Interest rates
What creates a major source of profit for commercial banks?
Is ensuring that the rate of interest they charge their customers (borrowers), is greater than the rate of interest they have to pay out ie to savers or in repayment for their own (regular) loans from the Bank of England
Why is it inevitable that if the Bank of England increases the base rate the commercial basis will pass on the increase to its customers?
In order to make a profit means they have to ensure that the rate of interest they charge their customers (borrowers), is greater than the rate of interest they have to pay out ie to savers or in repayment for their own (regular) loans from the Bank of England
How can banks be influenced by other factors when setting their interest rates?
Banking is now a highly competitive market, if the base rate came down, commercial banks can and probably will offer lower rates to their own customers
How can increasing interest rates effect savers?
Savers get a better rate of return in savings, encouraging economic agents to save more and spend Ltd
How can increasing interest rates effect borrowers?
Borrowers are required to pay higher rates of interest on loans that they’ve taken out. Thus, different economic agents will find that viewing is more expensive/less attractive and therefore spend less
How can increasing interest rates effect the exchange rate?
The exchange rate of the £ is likely to increase, this is due to “hot money” floating into an economy from overseas, speculators moving funds to the UK in order to exploit the higher rates of interest they can get. This increases demand for £’s, making exports more expensive, resulting in lower demand for exports
When interest rates increase, do exports become more or less expensive, how does this effect demand?
This increases the demand for £’s, making exports more expensive, resulting in lower demand for our exports
What are the 3 effects of interest rates?
- effects on savers
- effects on borrowers
- the exchange rate
What is the unifying theme when increasing interest rates effects the economy?
Increasing interest rates means that the demand for goods and services made in the UK declined, as a result of this AD decreased and shifts to the left
What happens in Figure 1 when interest rates increase?
Contractionary monetary policy:
AD shifts left, Real GDP (Y) moves left and PL decrease
When is monetary policy known as “contractionary”?
Increasing interest rates, it leads to lower level of economic activity and therefore a lower PL
What happens if you decrease interest rates?
Borrowing is cheaper/more attractive, encouraging more borrowing spending, AD shifts right, Y increases etc
When is monetary policy “expansionary”?
When you decrease interest rates
Analyse the diagram for expansionary monetary policy:
AD shifts to the right, closer to YFE, Real GDP increases, PL increases, smaller NOG
Is monetary policy always effective for targeting inflation?
It may not reduce inflation by very much
What is an example of monetary policy being ineffective for reducing inflation?
This was the experience for much of 2022/23 - inflation rates being continually increased but inflation stubbornly refusing to fall. One reason for this is that the 2022 inflation surge was almost all Cost-Push inflation. Lowering AD did not take the increase in costs as most of the costs came from external factors like energy price increases
How can monetary policy be very slow to take effect?
Eg most economic agents only make borrowing decisions on an irregular basis so may not be quickly impacted by the change of rates. Equally, many borrowers have agreed fixed repayment rates with their banks so are not yet affected; banks may not pass on the higher rates to savers as their profits from lending have fallen
What happens if American interest rates rise by more than the UK?
Hot money may flow out not in
How can monetary policy create trade off?
Even if the monetary policy works by bringing inflation under control and reestablishing stable prices, there may be a significant trade off between this and other government objectives, for example this could lead to lower economic growth, higher rates of unemployment requiring a large budget deficit etc
What are the disadvantages with monetary policy?
1) could be cost pay inflation rather than demand pull inflation
2) slow to take effect
3) hot money flowing or not in
4) trade off between other government objectives
