2.6.2 Demand-side Policies - Monetary Policy

Question 1

What is Monetary policy?

Answer 1

The changes to; interest rates and the money supply?

Question 2

What are the 3 tools under monetary policy?

Answer 2

• changes to interest rates
• changes to the money supply
• changes to the currency

Question 3

What is an interest rate?

Answer 3

The cost of borrowing or the reward for saving

Question 4

A low interest rates does what to the AD curve?

Answer 4

Shift it to the right

Question 5

What is the Monetary Policy Committee?

Answer 5

The independent body within the Bank of England whose role it is to conduct changes in monetary policy

Question 6

What is the bank rate?

Answer 6

The interest rate set by the Monetary Policy Committee in order to influence inflation

Question 7

What is the inflation target?

Answer 7

2%

Question 8

What is the transmission mechanism of monetary policy?

Answer 8

The process by which a change in interest rates has on inflation

Question 9

Explain the transmission mechanism of interest rates for bank lending on individuals?

Answer 9

Cut in i/r = increased borrowing because loans are cheaper = existing loans’ price falls = increase in consumption

Question 10

Explain the transmission mechanism of interest rates for bank lending on firms?

Answer 10

Cut in i/r = increased borrowing because loans are cheaper = firms’ existing loans are cheaper = greater profit = hire more staff = investment & consumption

Question 11

Explain the transmission mechanism of interest rates on mortgages?

Answer 11

Cut in i/r = existing mortgages fall in price = value of new mortgages fall = demand for houses increase = prices rise = wealth effect increased consumption

Question 12

What is expansionary monetary policy?

Answer 12

A fall in interest rates which should result in faster economic growth

Question 13

What is contractionary monetary policy?

Answer 13

An increase in interest rates which should result in slower economic growth

Question 14

An evaluation point for changes in interest rates affecting economic growth?

Answer 14

Keynesian economists would argue an increase in AD would only cause inflationary pressure if the economy is operating towards the full employment level

Question 15

What is hot money flows?

Answer 15

The idea that a rise in interest rates increases demand for saving money in that country, people then send money to that country raising the value of that currency

Question 16

Why should business investment be increased when expansionary monetary policy is applied?

Answer 16

Because the prospect of rising demand should prompt businesses to invest

Question 17

What is Quantitative Easing?

Answer 17

A process where the BoE buys government bonds off financial institutions

Question 18

What is the process of QE or assets purchasing?

Answer 18

• BoE creates credit and adds it to its account
• BoE buys government bonds off financial institutions
• financial institutions use the money they have received from BoE to lend out
• drives up investment and consumption

Question 19

Give 4 evaluation points for QE?

Answer 19

• banks may just keep the money to boost profits if they aren’t confident in their lending
• may weaken currency
• may fuel inflation
• magnitude of QE

Question 20

What is a reserve ratio?

Answer 20

The proportion of a banks money that has to be kept in reserve compared to that they are entitled to lend out

Question 21

What is the reserve ratio in the USA?

Answer 21

10%

Question 22

What is the reserve ratio in the USA?

Answer 22

10%

Question 23

What is the impact of cutting the reserve ratio and why?

Answer 23

Cutting the reserve ratio would increase the amount a bank can lend out because it doesn’t have to keep as much money in its reserves

Question 24

What is the impact of increasing the reserve ratio?

Answer 24

increasing the reserve ratio decreases the amount a bank is legally allowed to lend out, meaning the giving out of loans falls

Question 25

Give 3 evaluation points to reserve ratios?

Answer 25

- reducing ratio doesn’t mean more lending if banks aren’t confident - reducing ratio increases the likelihood of banks running out of cash - magnitude of the cut

Question 26

How does increasing the base rate of interest lead to a change in the rate of inflation?

Answer 26

Higher interest rate increase the incentive to save, lower levels of consumption and therefore a fall in AD. Higher i/r rates can also increase mortgage payments reducing disposable income further.

Question 27

How does increasing the base rate of interest lead to a fall in economic growth?

Answer 27

Higher interest rates lower the demand for credit and loans. Therefore discouraging investment which leads to a fall in consumption by firms. This will shift AD to the left leading to lower economic growth.

Question 28

How does an increase in the base rate of interest lead to hot money flows?

Answer 28

The interest rate transmission mechanism states that higher interest rates increases the incentive to save in the U.K. Increases demand for the currency and increases the exchange rate. Worsen the current account.