2.6.2 Monetary Policy and Interest Rates Flashcards
give some different interest rates
- savings rates
- mortgage rates
- credit card rates
define interest rates
the cost of borrowing, reward for saving and return for lending
who sets the base rate
the central bank
what is the base rate
the rate at which the Bank of England will lend to the financial system and influences the structure of other interest rates
who sets the commercial bank rate
set by individual banks for their own products
are commercial bank rates the same for each institution
no, vary from institution to institution
if the base rate increases, what will tend to happen to bank rates
also increase
what is inflation targeting
a monetary policy regime in which a central bank has an explicit target inflation rate for the medium term and announces this inflation target to the public
what is the main aim of inflation targeting
to stabilise economic agent behaviour and raise the credibility of macroeconomic policy
how does the inflation target impact consumers
- expect prices to rise by an average of 2%
- encourages them to consume before the price of goods increases
- helps them to make realistic wage demands
how does the inflation target impact firms
- expect prices to rise by an average of 2%
- allows them to increase their prices gradually, boosting profitability
- helps them in negotiations with unions
how does the inflation target impact the government
has a role in monitoring the progress of the central bank towards achieving their target
how does the inflation target impact abroad
- retains confidence of foreign investors that there is a stable macroeconomic environment
- maintains international competitiveness of UK companies if prices remain relatively low
how does the inflation target impact BoE
- responsibility to use monetary policy effectively to meet target
- collection and analysis of data to set most appropriate interest rate
What are nominal interest rates also known as
Money rate of interest
What are real interest rates
The nominal rate of interest adjusted for inflation
What is the formula for real interest rates
Nominal-rate of inflation
What are mortgage interest rates
The rates that lenders charge on a home loan
What is the effect of a rise in mortgage rates
Many home owners must pay more each month to service their debt, so a decrease in disposable income come, less spending on goods and services, slowdown in growth and maybe lower AD
what is the likely impact of increasing interest rates (borrowing)
- cost of borrowing increases for firms and households
- decreased investment and consumption decreases AD
- decreased AD leads to lower DP inflationary pressure
what is the likely impact of increasing interest rates (saving)
- increased reward for saving
- decreased consumption decreases AD
- decreased AD leads to lower DP inflationary pressure
what is the likely impact of increasing interest rates (price of currency)
- increased reward for saving in UK banks
- more foreign investors who want short term, high return will save in UK banks
- increased demand for the pound (SPICED)
- reduces net exports
define interest rate transmission mechanism
changing the rate of interest sets off a chain of reactions in the economy, many of which mean that AD will shift.
what is the general pattern for IR transmission mechanisms
- bank cuts the base rate (or increases)
- sends a signal to financial markets (e.g commercial banks)
- possible change in commercial interest rates
describe mechanism 1 for households (borrowing and loans), assume a cut in interest rates
- lower cost of borrowing
- households have access to new affordable loans (increases C and AD)
- households on existing loans with variable IR have greater discretionary incomes (increases C and AD)
describe mechanism 1 for firms (borrowing and loans), assume a cut in interest rates
- firms have access to new, more affordable loans (increases I and AD)
- firms with existing loans on variable IR have lower costs, greater profits (increases I and AD), leading to more jobs, greater incomes (increases C and AD)
describe mechanism 2 for households (mortgages), assume a cut in interest rates
- existing mortgages pay back lower interest, increasing effective disposable income (increases C and AD)
- if property equity also increases, positive wealth effect (increases C and AD)
describe mechanism 2 for consumers (mortgages), assume a cut in interest rates
- mortgages more affordable as lower IR, increased demand for new housing prompting increases investment from firms (increases AD)
- decreased reward for saving (increases C and AD)
define hot money flows
investors across the world will monitor interest rates in banks in different countries, and deposit money in banks with a high rate of savings to generate highest return.
describe mechanism 3 (hot money flows) when IR are high
when IR are high, foreign investors want to put money in UK banks, increasing demand for the pound (SPICED), worsens net exports and current account balance
describe mechanism 3 (hot money flows) when IR are low
if IR fall, demand for the pound decreases as foreign investors don’t want to save in UK banks so don’t need pounds, can improve current account position and net exports
what are the problems with interest rates / what do they depend on
- can worsen trade balance
- time lags (can take up to 2yrs to have full effect)
- size of change
- liquidity trap
- range of different interest rates
- confidence
- can decrease LRAS
how can higher interest rates worsen the trade balance
- cause stronger exchange rate due to hot money inflows
- SPICED: worsens trade balance on the current account on the balance of payments
explain liquidity trap
when interest rates are so low they cannot be decreased any further to stimulate AD
when was the liquidity trap a particular problem
- 2008/09 recession
- 2020 pandemic
explain range of different interest rates
there are a range of different interest rates and not all of them are affected by the bank of England base rate
explain how interest rates depend on confidence
if confidence is low then consumers and businesses do not want to borrow or banks do not want to lend to them
explain how high interest rates can decrease LRAS
high interest rates over a long period of time will discourage investment and decrease LRAS
explain how negative interest rates work
- a central bank charges commercial banks interest for holding funds with them
- designed to get commercial banks to lend out to people and businesses rather than hold money with central bank
give an example of where negative interest rates where used
Japan, in response to deflation to try and stimulate economy
