3.2 Monetary Policy

Question 1

Monetary Policy Diagram

Answer 1

Question 2

What is Monetary Policy?

Answer 2

Monetary policy is the use of interest rates, money supply, and the exchange rate to influence aggregate demand in an economy.

Question 3

How can the central bank reduce interest rates, and why does it matter?

Answer 3

The central bank can reduce interest rates by either decreasing the reserve requirement, reducing the repo/bank rate (discount rate), or buying bonds using open market operations. By lowering interest rates, people and businesses are more likely to borrow money, thus increasing investment and consumption. This increases aggregate demand, leading to a rise in real GDP and inflation. Lower interest rates can also lead to a fall in the exchange rate, making exports cheaper and imports more expensive, increasing net exports and aggregate demand.

Question 4

How does reducing the reserve requirement affect interest rates?

Answer 4

The reserve requirement is the level of reserves as a percentage of bank deposits that commercial banks must keep in the Bank of England. By reducing the reserve requirement, less money needs to be kept in the Bank of England, leading to an increase in the money supply from Sm1 to Sm2. The increase in the money supply leads to a fall in interest rates from i1 to i2.

Question 5

How does reducing the repo/bank rate (discount rate) affect interest rates?

Answer 5

The repo rate is the interest rate charged to commercial banks when they borrow from the Bank of England. By reducing the repo/bank rate, commercial banks pay less in interest to the Bank of England, leading to an increase in the money supply from Sm1 to Sm2. The increase in the money supply leads to a fall in interest rates from il to i2.

Question 6

How does buying bonds using open market operations affect interest rates?

Answer 6

The Bank of England can engage in secondary bond markets by buying up bond held by commercial banks. By buying bonds using open market operations, the Bank of England increases the money supply from Sm1 to Sm2 by replacing less liquid financial assets (paper IOUs) for liquid deposits. This leads to a fall in interest rates from i1 to i2.

Question 7

How does a cut in interest rates affect borrowing costs and consumption in the economy?

Answer 7

A cut in interest rates reduces the cost of borrowing, making it cheaper for consumers to borrow and reducing the opportunity cost of doing so. This increases consumption in the AD equation, shifting AD to the right from AD1 to AD2.

Question 8

How does a cut in interest rates affect the savings ratio in the economy?

Answer 8

A cut in interest rates reduces the rate of return on savings, reducing the incentive to save and increasing the incentive to spend or borrow to spend. As a consequence, the savings ratio in the economy will decrease with more consumer spending taking place. This increases consumption in the AD equation, shifting AD to the right from AD1 to AD2.

Question 9

How does a cut in interest rates affect the disposable income of homeowners with tracker or variable rate mortgages?

Answer 9

A cut in interest rates will reduce the monthly payments for homeowners with tracker or variable rate mortgages, boosting their disposable income and increasing their marginal propensity to consume. This boosts consumption in the economy and shifts AD to the right from AD1 to ADZ.

Question 10

How does a cut in interest rates affect the cost of borrowing for firms?

Answer 10

A cut in interest rates will reduce the cost of borrowing for firms, enabling them to reach their hurdle rate more easily (the required rate of return for investment projects to go ahead). This increases the marginal propensity for firms to invest, increasing I in the AD equation and shifting AD to the right from AD1 to AD2.

Question 11

How does a decrease in relative UK interest rates affect the trade balance of the current account?

Answer 11

If relative UK interest rates fall, investors will move their money out of UK financial institutions to seek better interest rates elsewhere in the world, leading to ‘hot money’ outflows from the UK and increasing the supply of the pound. A weak exchange rate makes exports cheaper and imports dearer. Economic theory suggests that the demand for imports and therefore the expenditure on imports will decrease, whereas the demand for exports and therefore the revenue generated by exports will increase. Both effects lead to an improvement in the trade balance of the current account and reduce a current account deficit or move it to surplus. As (X-M1) is a component of aggregate demand, AD will shift to the right from AD1 to AD2.

Question 12

How does expansionary monetary policy affect actual growth in the economy?

Answer 12

As AD increases due to expansionary monetary policy, firms respond by increasing output and exhausting spare capacity, resulting in an increase in actual growth from Y1 to Y2. This increase in output is an increase in real GDP, which is an increase in economic growth.

Question 13

How does expansionary monetary policy affect unemployment in the economy?

Answer 13

As the demand for goods and services increases due to expansionary monetary policy, firms will need more workers to produce extra output, thus reducing unemployment. This is because labour is a derived demand, derived from the demand for goods and services. Therefore, as AD increases, unemployment decreases.

Question 14

How does a cut in interest rates affect the cost of borrowing for firms?

Answer 14

A cut in interest rates reduces the cost of borrowing for firms, enabling them to reach their hurdle rate more easily. The hurdle rate is the required rate of return for investment projects to go ahead. This reduction in the cost of borrowing increases the marginal propensity for firms to invest.

Question 15

How does increased investment due to a cut in interest rates affect the quantity and quality of the capital stock in the economy?

Answer 15

Increased investment due to a cut in interest rates increases the marginal propensity for firms to invest, which improves both the quantity and the quality of the capital stock in the economy. This increase in investment and improvement in the capital stock shifts the LAS curve to the right from LRAS1 to LRAS2.

Question 16

How does expansionary monetary policy contribute to inflation in the economy?

Answer 16

Expansionary monetary policy is likely to increase inflation in the economy as spare capacity is exhausted, leading to increased competition for resources and pressure on existing factors of production. This puts upward pressure on prices and causes demand-pull inflation, shifting the price level from P1 to P2.

Question 17

What is a liquidity trap, and how can it impact the effectiveness of traditional expansionary monetary policy?

Diagram too

Answer 17

Keynesian Economists argue that interest rates have a lower bound when the economy is in a liquidity trap. This is where interest rates have reached such a low that individuals have already converted illiquid financial assets into liquid forms e.g. cash, to spend on goods and services (the moneymarket demand curve, D1, becomes flat; a liquidity trap). Consequently, traditional expansionary monetary policy to increase the money supply from Sm1 to Sm2 will not lower interest rates below il, thus failing to stimulate borrowing, growth and jobs in the economy. More extreme monetary policy measures or a switch to expansionary fiscal policy may be needed instead.

Question 18

What are the negative consequences of expansionary monetary policy on savers in the economy?

Answer 18

Expansionary monetary policy can have a large negative impact on savers who will receive a lower rate of return on their assets. This can severely affect the living standards of elderly individuals who save most of their money in pension funds. The consequence would be greater wealth inequality in the economy, with the poor struggling to find assets that can offer a good rate of return, whereas the rich are more likely to take greater risk and search to find higher yielding assets.

Question 19

Why might a contractionary monetary policy be used?

Answer 19

A contractionary monetary policy might be used to control inflation. As interest rates increase, consumption (C), investment (I), and net exports (X-M) will decrease, reducing aggregate demand (AD). Consequently, as the level of spare capacity increases, there will be less pressure on existing factors of production, reducing the rate at which their prices rise and lowering the rate of inflation.

Question 20

How might a contractionary monetary policy protect against credit/asset bubbles and systemic risk in the banking sector?

Answer 20

Periods of prolonged low interest rates encourage excessive borrowing, which could drive up debt and asset prices beyond sustainable levels. As a consequence, the economy becomes prone to a negative demand-side shock if asset prices were to fall, or if households default on loan repayments. A contractionary monetary policy can protect against these risks by increasing interest rates and reducing borrowing, preventing debt and asset prices from reaching unsustainable levels and reducing the likelihood of bank failure and systemic risk in the banking sector.

Question 21

How might a contractionary monetary policy make housing more affordable?

Answer 21

A contractionary monetary policy can make housing more affordable by increasing interest rates, making monthly mortgage payments more expensive and lowering the demand for housing, which reduces house prices. This is especially important for first-time buyers and those on low incomes, who can get on the housing ladder and afford secure accommodation while also reducing wealth inequalities in society through the acquisition of a valuable asset.

Question 22

How might a contractionary monetary policy promote more sustainable lending and borrowing?

Answer 22

Very low and affordable interest rates attract a large range of borrowers, regardless of whether they are creditworthy. As a consequence, lenders and borrowers take excessive risk, which is not in the interests of long-term economic growth, while also promoting a long-term dependency on credit-led consumption and investment. Higher interest rates thus promote greater sustainability in the amount of credit-based activity in the economy.

Question 23

How might a contractionary monetary policy encourage saving and investment?

Answer 23

With higher interest rates, the rates of return on savings rise, increasing the marginal propensity to save. As more saving takes place, banks have greater funds available to lend out in the form of loans to companies or entrepreneurs looking to borrow to invest, thus promoting both short-term and long-term sustainable growth in the economy.

Question 24

How might a contractionary monetary policy improve the current account balance?

Answer 24

A contractionary monetary policy, as an expenditure-reducing policy, by reducing aggregate demand in the economy, will reduce household incomes and thus reduce the marginal propensity to import. As a consequence, there will be less sucking in of imports, a lower demand for imports, and lower expenditure on imports, which, ceteris paribus, will improve the trade balance of the current account and thus improve the overall current account balance.

Question 25

What is the potential risk of a contractionary monetary policy?

Answer 25

A potential risk of a contractionary monetary policy is that as aggregate demand (AD) falls, it could lead to a decrease in economic growth and an increase in unemployment, potentially resulting in a recession. Even if inflation is above the target, central banks must be cautious in deciding the timing and level of the interest rate rise to avoid conflict with macro objectives if the economy is in a fragile state.

Question 26

What is the impact of a contractionary monetary policy on indebted economic agents?

Answer 26

Indebted economic agents, such as mortgage payers, consumers with credit card debt, or firms, could be negatively affected by a contractionary monetary policy. These agents may be reliant on low-interest rates to afford repayments or may have adjusted their way of life to very low rates. If rates rise, these agents may default on their loans, significantly harming their living standards as assets are taken away while firms may have to shut down, causing unemployment.

Question 27

How does a contractionary monetary policy affect borrowing for investment?

Answer 27

A contractionary monetary policy could detract borrowing for investment as the cost of borrowing for firms increases, making it harder to reach their hurdle rate for investment projects to go ahead. Although higher savings could generate more loans for investment, the direct impact of rate rises is likely to be lower investment, harming productivity, international competitiveness, and long-term growth rates.

Question 28

What is the impact of higher interest rates on the exchange rate and the current account position?

Answer 28

A contractionary monetary policy will strengthen the exchange rate and could deteriorate the current account position. A strong exchange rate makes exports dearer and imports cheaper. The demand for imports and expenditure on imports will increase, whereas the demand for exports and revenue generated by exports will decrease. Both effects will lead to a worsening in the trade balance and an increase in the current account deficit, conflicting with another macroeconomic objective.

Question 29

What is the impact of the initial level of economic activity on an expansionary monetary policy?

Answer 29

The impact of the initial level of economic activity on an expansionary monetary policy is that if the economy is initially operating with a large level of spare capacity (a large negative output gap), an increase in aggregate demand (AD) would most likely lead to a larger increase in output and decrease in unemployment. However, if the economy is close to fully utilizing all available factors of production, it becomes extremely difficult for firms to increase production, leading to less increase in output and employment. In this case, there would be enormous pressure on the limited factors of production remaining, leading to a greater rise in inflation and a large deterioration of the current account position.

Question 30

What is the impact of the size of the interest rate cut on an expansionary monetary policy?

Answer 30

The impact of the size of the interest rate cut on an expansionary monetary policy depends on the size of the interest rate cut. A large interest rate cut, for example, from 5% to 2%, would substantially reduce the cost of borrowing, making it more likely to incentivize consumers and firms to borrow money for consumption and investment purposes, while the exchange rate is most likely to depreciate by a greater margin, increasing net exports. Conversely, a small decrease in interest rates, such as from 0.75% to 0.5%, is unlikely to stimulate a large increase in borrowing or substantially increase the disposable income of those on variable rate or tracker mortgages. If interest rates are already this low, it most likely suggests a lack of confidence in the economy, and aggregate demand is unlikely to increase, if at all, leaving the four key macroeconomic objectives of the government unaltered.

Question 31

What is the impact of consumer and business confidence on an expansionary monetary policy?

Answer 31

The impact of consumer and business confidence on an expansionary monetary policy is that if the level of consumer and business confidence is very low, a reduction in interest rates, regardless of the size of the cut, may have little impact on stimulating aggregate demand as consumers may be mindful of their future employment prospects. If the economy is in recession, for example, consumers may be cautious against redundancies and job losses and may be more inclined to save money. Businesses may be concerned about lower profits and thus may be unwilling to borrow money to fund investment projects. Aggregate demand is unlikely to increase if at all, leaving the four key macroeconomic objectives of the government unaltered.

Question 32

What is the impact of the time lags for interest rates on an expansionary monetary policy?

Answer 32

The impact of the time lags for interest rates on an expansionary monetary policy is that it takes time for interest rates to have a full impact on the wider economy, typically 2 years. A change in interest rates will first feed through the transmission mechanism, affecting house prices, commercial bank interest rates, etc. before having an impact on spending and aggregate demand. It also takes time for consumers, firms, and foreign investors to react to a change in interest rates. Therefore, any immediate impact from a fall in interest rates may not be as large as the medium-term (2-year) impact.

Question 33

What is the impact of the initial level of interest rates on an expansionary monetary policy?

Answer 33

The impact of the initial level of interest rates on an expansionary monetary policy is that if the level of interest rates is cut from a high level (e.g., 5%), the rate cut is more likely to have a positive effect of increasing aggregate demand. Consumers and firms will react favorably as this represents a substantial fall in the cost of borrowing and quite a disincentive to save. Interest rates falling from an initial low level (e.g., from 0.75% to 0.5%) may be indicative of a very weak economy in recession where confidence levels may be very low. Similarly, if interest rates had been low for a long time without much effect, a small rate change to another very low level is unlikely to deal with more serious underlying weaknesses in the economy, particularly low consumer and business confidence. Therefore, the initial level of interest rates plays a crucial role in determining the impact of an expansionary monetary policy on the economy’s macroeconomic objectives.

Question 34

What is the impact of the willingness of banks to lend on an expansionary monetary policy?

Answer 34

The impact of the willingness of banks to lend on an expansionary monetary policy is that banks, particularly in times of deep recession or financial crisis, are extremely concerned about their liquidity and profitability. Their willingness to take risks is extremely low, reducing their willingness to lend even to relatively safe borrowers. Furthermore, even if banks are willing to lend, they may decide to only pass on a small percentage of the rate cut if they are averse to risk, reducing the borrowing incentives for consumers and firms and thus the positive aggregate demand impact. This would lead to a smaller increase in spending and output than expected from an interest rate cut, potentially leading to a weaker impact on the economy’s macroeconomic objectives.