3.2 Monetary Policy Flashcards
what is monetary policy ?
manipulation of the money supply, interest rate, exchange rate and the amount of credit available
what is the monetary transmission mechanism ?
Process by which a change in interest rates affects aggregate demand and inflation
monetary policy can influence both parts of AD - domestic & external demand
what is the central bank and what is its role?
the central bank is the organisation charged with responsibility for maintaining price stability by making monetary policy decisions.
the central bank role is to manage monetary policy
what is expansionary monetary policy ? with diagram
see sheet for diagram - page 182
government policy to decrease the rate of interest/ increase money supply in order to stimulate economic activity and increase the rate of inflation
what is discretionary income ?
income remaining once tax and essential housing costs, such as mortgage payments, have been paid
what is contractionary monetary policy ? with diagram
see diagram sheet page 183
government policy to increase the rate of interest/decrease money supply in order to reduce economic activity and the rate of inflation
what is the money supply?
the quantity of money in circulation in the economy
what is quantitative easing ?
process by which liquidity in the economy is increased when the central bank purchases assets from commercial banks
what are the two types of inflation rate targets and explain
asymmetric inflation target- when fluctuations above the inflation target are more significant than fluctuations below
symmetric inflation target- when fluctuations above and below the inflation target are equally weighted
what are the inflation rate targets for the U.K?
provide transparency and accountability to the central bank
manage expectations - if the target is credible then economic agents build it into their behaviour and it becomes a self fulfilling prophecy
what is hot money ?
short term capital flow that responds to changes in relative interest rates
what factors does the effectiveness of using monetary policy to achieve the Govts macroeconomic objectives depend on?
Time lag- the changes in monetary policy take time to work through.
Lack of targeting- can’t target specific sectors
Business and consumer confidence- if economic agents are uncertain about the future health of the economy they are less likely to respond to a monetary stimulus such as a reduction in the rate of interest
the liquidity trap- reaches a point where more liquidity is pumped into economy without impact of a rise in economic output
what is the liquidity trap ?
when a reduction in the interest rate no longer stimulates economic activity because there is too much liquidity in the system
Describe Expansionary monetary policy
A reduction in the rate of interest reduces the cost of borrowing and the reward for saving, resulting in a rise in discretionary incomes as interest rate payments on variable rate mortgages and loans fall and consumers are less incentivised to save
The rise in discretionary income increases consumption on products with income elastic demand
Private sector firms are more inclined to invest
The rise in consumption and investment increases AD, shifting the D curve outwards and through the multiplier there will be a further increase in AD and a 2nd shift outwards of the AD curve resulting in an increase in real GDP, a fall in unemployment and an increase in the price level
The rise in consumption could increase demand for imports which could increase the trade deficit on the current account of the balance of payments
Describe contractionary monetary policy ?
A increase in the rate of interest increases the cost of borrowing and the reward for saving, resulting in a reduction in discretionary incomes as interest rate payments on variable rate mortgages and loans increase and consumers are incentivised to save
The fall in discretionary income decreases consumption on products with income elastic demand
Private sector firms are less inclined to invest
The rise in consumption and investment decreases AD, shifting the D curve inwards and through the negative multiplier there will be a further decrease in AD and a 2nd shift inwards of the AD curve resulting in a fall in real GDP, a rise in unemployment and an decrease in the price level
The fall in consumption could decrease demand for imports which could decrease the trade deficit on the current account of the balance of payments
