3.2 Monetary Policy Flashcards
Monetary Policy Diagram
What is Monetary Policy?
Monetary policy is the use of interest rates, money supply, and the exchange rate to influence aggregate demand in an economy.
How can the central bank reduce interest rates, and why does it matter?
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.
How does reducing the reserve requirement affect interest rates?
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.
How does reducing the repo/bank rate (discount rate) affect interest rates?
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.
How does buying bonds using open market operations affect interest rates?
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.
How does a cut in interest rates affect borrowing costs and consumption in the economy?
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.
How does a cut in interest rates affect the savings ratio in the economy?
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.
How does a cut in interest rates affect the disposable income of homeowners with tracker or variable rate mortgages?
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.
How does a cut in interest rates affect the cost of borrowing for firms?
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.
How does a decrease in relative UK interest rates affect the trade balance of the current account?
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.
How does expansionary monetary policy affect actual growth in the economy?
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.
How does expansionary monetary policy affect unemployment in the economy?
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.
How does a cut in interest rates affect the cost of borrowing for firms?
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.
How does increased investment due to a cut in interest rates affect the quantity and quality of the capital stock in the economy?
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.
How does expansionary monetary policy contribute to inflation in the economy?
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.
What is a liquidity trap, and how can it impact the effectiveness of traditional expansionary monetary policy?
Diagram too
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.
What are the negative consequences of expansionary monetary policy on savers in the economy?
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.
Why might a contractionary monetary policy be used?
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.
How might a contractionary monetary policy protect against credit/asset bubbles and systemic risk in the banking sector?
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.
How might a contractionary monetary policy make housing more affordable?
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.
How might a contractionary monetary policy promote more sustainable lending and borrowing?
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.
How might a contractionary monetary policy encourage saving and investment?
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.
How might a contractionary monetary policy improve the current account balance?
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.