2.6.2 Monetary Policy and Interest Rates

Question 1

give some different interest rates

Answer 1

• savings rates
• mortgage rates
• credit card rates

Question 2

define interest rates

Answer 2

the cost of borrowing, reward for saving and return for lending

Question 3

who sets the base rate

Answer 3

the central bank

Question 4

what is the base rate

Answer 4

the rate at which the Bank of England will lend to the financial system and influences the structure of other interest rates

Question 5

who sets the commercial bank rate

Answer 5

set by individual banks for their own products

Question 6

are commercial bank rates the same for each institution

Answer 6

no, vary from institution to institution

Question 7

if the base rate increases, what will tend to happen to bank rates

Answer 7

also increase

Question 8

what is inflation targeting

Answer 8

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

Question 9

what is the main aim of inflation targeting

Answer 9

to stabilise economic agent behaviour and raise the credibility of macroeconomic policy

Question 10

how does the inflation target impact consumers

Answer 10

• 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

Question 11

how does the inflation target impact firms

Answer 11

• expect prices to rise by an average of 2%
• allows them to increase their prices gradually, boosting profitability
• helps them in negotiations with unions

Question 12

how does the inflation target impact the government

Answer 12

has a role in monitoring the progress of the central bank towards achieving their target

Question 13

how does the inflation target impact abroad

Answer 13

• retains confidence of foreign investors that there is a stable macroeconomic environment
• maintains international competitiveness of UK companies if prices remain relatively low

Question 14

how does the inflation target impact BoE

Answer 14

• responsibility to use monetary policy effectively to meet target
• collection and analysis of data to set most appropriate interest rate

Question 15

What are nominal interest rates also known as

Answer 15

Money rate of interest

Question 16

What are real interest rates

Answer 16

The nominal rate of interest adjusted for inflation

Question 17

What is the formula for real interest rates

Answer 17

Nominal-rate of inflation

Question 18

What are mortgage interest rates

Answer 18

The rates that lenders charge on a home loan

Question 19

What is the effect of a rise in mortgage rates

Answer 19

Many home owners must pay more each month to service their debt, so a decrease in disposable income, less spending on goods and services, slowdown in growth and maybe lower AD

Question 20

what is the likely impact of increasing interest rates (borrowing)

Answer 20

• cost of borrowing increases for firms and households
• decreased investment and consumption decreases AD
• decreased AD leads to lower DP inflationary pressure

Question 21

what is the likely impact of increasing interest rates (saving)

Answer 21

• increased reward for saving
• decreased consumption decreases AD
• decreased AD leads to lower DP inflationary pressure

Question 22

what is the likely impact of increasing interest rates (price of currency)

Answer 22

• 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

Question 23

define interest rate transmission mechanism

Answer 23

changing the rate of interest sets off a chain of reactions in the economy, many of which mean that AD will shift.

Question 24

what is the general pattern for IR transmission mechanisms

Answer 24

• bank cuts the base rate (or increases)
• sends a signal to financial markets (e.g commercial banks)
• possible change in commercial interest rates

Question 25

describe mechanism 1 for households (borrowing and loans), assume a cut in interest rates

Answer 25

- 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)

Question 26

describe mechanism 1 for firms (borrowing and loans), assume a cut in interest rates

Answer 26

- 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)

Question 27

describe mechanism 2 for households (mortgages), assume a cut in interest rates

Answer 27

- those on 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)

Question 28

describe mechanism 2 for consumers (mortgages), assume a cut in interest rates

Answer 28

- mortgages more affordable as lower IR, increased demand for new housing prompting increased investment from firms (increases AD) - decreased reward for saving (increases C and AD)

Question 29

define hot money flows

Answer 29

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.

Question 30

describe mechanism 3 (hot money flows) when IR are high

Answer 30

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

Question 31

describe mechanism 3 (hot money flows) when IR are low

Answer 31

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

Question 32

what are the problems with interest rates / what do they depend on

Answer 32

- 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

Question 33

how can higher interest rates worsen the trade balance

Answer 33

- cause stronger exchange rate due to hot money inflows - SPICED: worsens trade balance on the current account on the balance of payments

Question 34

explain liquidity trap

Answer 34

when interest rates are so low they cannot be decreased any further to stimulate AD

Question 35

when was the liquidity trap a particular problem

Answer 35

- 2008/09 recession - 2020 pandemic

Question 36

explain range of different interest rates

Answer 36

there are a range of different interest rates and not all of them are affected by the bank of England base rate

Question 37

explain how interest rates depend on confidence

Answer 37

if confidence is low then consumers and businesses do not want to borrow or banks do not want to lend to them

Question 38

explain how high interest rates can decrease LRAS

Answer 38

high interest rates over a long period of time will discourage investment and decrease LRAS

Question 39

explain how negative interest rates work

Answer 39

- 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

Question 40

give an example of where negative interest rates where used

Answer 40

Japan, in response to deflation to try and stimulate economy