3. Financial Markets & Monetary Policy - The Central Bank & Monetary Policy

Question 1

What is a central bank?

Answer 1

The monetary authority and major regulatory bank in a country.

Question 2

What are the main functions of a central bank?

Answer 2

Monetary policy functionFinancial stability & regulatory functionPolicy operation functionsFinancial infrastructure provision function

Question 3

What are the monetary policy functions of a central bank?

Answer 3

Setting of the main monetary policy interest rate, Quantitative easing, Exchange rate intervention (managed/fixed currency systems)

Question 4

What are the financial stability & regulatory functions of a central bank?

Answer 4

Supervision of the wider financial system, Prudential policies designed to maintain financial stability

Question 5

What are the policy operation functions of a central bank?

Answer 5

Lender of last resort to the banking system, Managing liquidity in the commercial banking system

Question 6

What are the financial infrastructure provision functions of a central bank?

Answer 6

Overseeing the payments systems used by banks / retailers / credit card companies, Debt management, Handling the issue and redemption of issues of government debt

Question 7

What is monetary policy?

Answer 7

The use of interest rates, the money supply and exchange rates to meet government objectives.

Question 8

How can the central bank use monetary policy to meet government objectives?

Answer 8

1. Changing Interest Rates - Base Rate changes2. Changing the money supply - Quantitative Easing & Credit CreationNOTE: In the UK we have a floating ER meaning it isn’t used as part of Monetary Policy

Question 9

How do the central banks change interest rates to meet government objectives?

Answer 9

The Central Bank decrease the Base Rate - Banks can borrow at lower rates - Banks can in turn lower there interest rates - this makes it cheaper to borrow - more ppl will borrow - more consumer spending and investment - more AD - this may be used to increase growth and employment. The reverse process could be used to reduce inflation and improve our Balance of Payments.

Question 10

How do the central banks change the money supply to meet government objectives?

Answer 10

1. QE - the government print money to finance the budget deficit - they buy all the bonds the gov. have issued to banks, firms etc. - this means banks have an increase in cash reserves - they will want to turn cash reserves into loans bc they offer better returns - increased loans on the part of banks is done by lowering interest rates - increased borrowing - increased CS and I - increased ADAlso, gov. buy its bonds - demand for bonds increases - bond yields decrease - loans now offer comparatively better returns than bonds - increased loans …2. Credit Creation - This is effectively just the money multiplier effect - by encouraging loaning banks the gov. increase the supply of money - £100 deposit - £10 reserved, £90 lent - this £90 eventually deposited - £9 kept, £81 lent - so on - increased money supply = inflationary according to Fisher

Question 11

What are the current objectives of the UK’s Monetary Policy?

Answer 11

The UK want to achieve Monetary Stability, meaning stable prices and confidence in the currency. The current targeted rate of inflation in the UK is 2% (+/- 1%).

Question 12

Who are responsible for orchestrating UK Monetary Policy and meeting government targets?

Answer 12

The Monetary Policy Committee .

Question 13

Who are the Monetary Policy Committee?

Answer 13

The Bank of England has been independent of government since 1997. The Monetary Policy Committee (MPC) are a branch of the BoE and has nine members, some of whom are appointed by the government and some by the Bank of England. The Governor of the Bank has the casting vote if there is an equally split decision on interest rates. Each month the MPC meets to consider the latest news on the UK and global economy.Their job is to make a judgement on what is the appropriate level of base interest rates for the UK economy consistent with the need to meet an inflation target set by the government.

Question 14

What are the factors considered by the MPC when setting the Bank Rate?

Answer 14

GDP growth and spare capacity - Their main task is to set monetary policy so that AD grows in line with productive potential.Bank lending and consumer credit figures.Equity markets (share prices) and house prices.Consumer confidence and business confidence – confidence surveys can provide “advance warning” of turning points in the economic cycle. These are called ‘leading indicators’.Growth of wages, average earnings and unit labour costs - wage inflation might be a cause of cost-push inflation so the Bank of England looks carefully at what is happening to wages. Unemployment figures - and survey evidence on the scale of shortages of skilled labour.Trends in global foreign exchange markets – a weaker exchange rate could be seen as a threat to inflation because it raises the prices of imported goods and services. A strong exchange rate might bring down inflation but risk causing a deeper economic slowdown via a fall in exports.

Question 15

Which two sets of indicators do the MPC consider when setting the bank rate?

Answer 15

The key point is that the Monetary Policy Committee considers many indicators from both the demand and the supply-side of the economy.

Question 16

What else do the MPC have to consider when setting Bank Rates and why?

Answer 16

They then have to make a judgement about what this evidence says about inflationary pressures over a two year forecast horizon. This is because when interest rates are changed, it takes time for them to have an effect on aggregate demand and prices.

Question 17

What is the transmission mechanism of Monetary Policy?

Answer 17

These are the ways in which changes in interest rates influence aggregate demand, output and prices.

Question 18

What are the ways changes in interest rates influence AD, output and prices?

Answer 18

1. Lending and borrowing rates charged in the financial markets2. Housing market & house prices3. Effective disposable incomes of mortgage payers4. Disposable income of savers5. Consumer demand for credit6. Business capital investment7. Consumer and business confidence8. Interest rates and the exchange rate

Question 19

How do lending and borrowing rates charged in the financial markets influence AD, O & P?

Answer 19

When the Bank’s own base interest rate goes up, then commercial banks and building societies will typically increase how much they charge on loans and the interest that they offer on savings. This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend — and so depresses aggregate demand. (& vice versa)

Question 20

How does the housing market and housing market prices influence AD, O & P?

Answer 20

Higher interest rates increase the cost of mortgages and reduce the demand for housing. This will affect household wealth and put a squeeze on equity withdrawal (where consumers borrow money secured on rising house prices)

Question 21

How do effective disposable incomes of mortgages payers influence AD, O & P?

Answer 21

If interest rates increase, the income of homeowners who have variable-rate mortgages will fall – leading to a decline in their effective purchasing powerAlso, the effects of a rate change are greater when the level of existing mortgage debt is high as this makes property owners more exposed to higher costs of repaying debts.

Question 22

How does consumer demand for credit influence AD, O & P?

Answer 22

Higher interest rates increase the cost of paying the debt on credit cards and should lead to a deceleration in retail sales and spending on consumer durables especially items such as cars and household appliances which are typically bought on credit.

Question 23

How does business capital investment influence AD, O & P?

Answer 23

Firms often take the actual and expected level of interest rates into account when deciding whether or not to go ahead with new capital investment spendingAlso, a rise in interest rates may dampen confidence and lead to a reduction in planned capital investment. However, many factors influence investment decisions other than rate changes.

Question 24

How does consumer and business confidence influence AD, O & P?

Answer 24

The relationship between interest rates and business and consumer confidence is complex, and depends crucially on prevailing economic conditions. For example, when businesses and consumers are worried about the recession, an interest rate cut can boost confidence because it reassures the public that the Bank is alert to the dangers of a slump. Some people might take emergency interest rate cuts as a sign that the wider economy is in difficulty and hard times lie ahead.

Question 25

How does the influence of interest rates on exchange rates influence AD, O & P?

Answer 25

Higher UK interest rates might lead to an appreciation of the exchange rate particularly if UK interest rates rise relative to those in the Euro Zone and the United States attracting inflows of “hot money” into the British banking system.A stronger exchange rate reduces the competitiveness of UK exports in overseas markets because it makes our exports appear more expensive when priced in a foreign currency leading to a decline in export volumes and market share.It also reduces the sterling price of imported goods and services leading to lower prices and rising import penetration. If the trade deficit in goods and services widens, this is a net withdrawal of demand from the circular flow and acts to reduce excess demand in the economy.

Question 26

How do disposable incomes of savers influence AD, O & P?

Answer 26

A rise in interest rates boosts the disposable income of people who have paid off their mortgage and who have positive net savings in bank and building society accountsBut if the rate of interest is lower than the rate of inflation, then the annual real return on saving will be negative.

Question 27

How do changes in the ER affect AD and macroeconomic policy objectives?

Answer 27

A stronger exchange rate reduces the competitiveness of UK exports in overseas markets because it makes our exports appear more expensive when priced in a foreign currency leading to a decline in export volumes and market share.It also reduces the sterling price of imported goods and services leading to lower prices and rising import penetration. If the trade deficit in goods and services widens, this is a net withdrawal of demand from the circular flow and acts to reduce excess demand in the economy.

Question 28

What is forward guidance and when may it be used by the MPC to influence AD?

Answer 28

Forward Guidance is when the MPC release a document detailing what they expect future inflation to look like and explaining why it is as it is currently. This is used by the MPC to reduce inflationary expectations, if people se inflation above or below the 2% target they will expect high or low inflation respectively. This creates problems as Phillips said inflationary expectations underpin the SRPC, therefore the MPC use forward guidance to manage inflationary expectations.