4.12.3 - Central Banks and Monetary Policy

Question 1

What is a central bank?

Answer 1

A national bank that provides financial and banking services for its country’s government and banking system.

Implements the government’s monetary policy and issuing currency.

Question 2

What is the UK central bank?

Answer 2

The Bank of England.

Question 3

When was the BoE nationalised?

Answer 3

1946.

Question 4

What are the two key functions of a central bank?

Answer 4

• Help the government maintain macroeconomic stability
• Bring about financial stability in the monetary system

Question 5

What is the governmental inflation target?

Answer 5

2%.

Question 6

How can the central bank help banks and the financial system?

Answer 6

• Act as a lender of last resort (help banks)
• Monitor and regulate the financial system (regulate the banks)

Question 7

What are policy objectives?

Answer 7

The target the BoE aims to hit.

Question 8

What are policy instruments?

Answer 8

The tools the BoE uses to try and achieve policy objectives.

Question 9

How can policy objectives be divided?

Answer 9

Ultimate and intermediate.

Question 10

How can policy instruments be divided?

Answer 10

Directly affecting the supply of new deposits or influencing the creation of bank deposits by affecting demand for loans or credit.

Question 11

What is the monetary policy committee?

Answer 11

The part of the BoE which implements UK monetary policy.

Question 12

What is the bank rate?

Answer 12

The rate of interest the BoE pays to commercial banks on their deposits at the BoE.

Question 13

What does monetary policy affect in the AD equation?

Answer 13

• Consumption
• Investment
• Imports
• Exports

Question 14

How does the BoE decide whether to lower or raise the bank rate?

Answer 14

• Current rate of inflation
• Existence of inflationary / deflationary pressure
• Consumer and business confidence
• Growth rate of the economy
• Levels of employment / unemployment
• etc.

Question 15

What leeway is the MPC given?

Answer 15

1% above or below the 2% CPI inflation target.

Question 16

What happens if the CPI inflation rate exceeds the leeway?

Answer 16

The governor of the BoE must write an open letter to the CotE explaining why.

Question 17

What is the primary objective of the bank? And why are there trade-offs with other goals?

Answer 17

The primary objective is price stability.

The BoE must achieve price stability while supporting the government’s economic policy objectives.

Question 18

What is contractionary monetary policy?

Answer 18

Uses higher interest rates to decrease AD and shift AD left.

Question 19

Draw a graph of the effects of contractionary monetary policy.

Answer 19

Question 20

How can contractionary monetary policy cause a recession?

Answer 20

If the SRAS curve is very steep, real output may fall too far and push the economy in to a recession.

This could be exacerbated by a possible multiplier effect to push the curve further to the left.

Question 21

How does an increase in interest rates decrease AD?

Answer 21

• Higher interest rates reducing household consumption (C)
• Higher interest rates reducing business investment (I)
• Changes in interest rates affect exports and imports via the exchange rate

Question 22

How do contractionary interest rates reducing household consumption decrease AD?

Answer 22

Higher interest rates incentivise saving and higher saving means that less income is therefore available to be consumed.

The cost of household borrowing also increases, increasing the cost of servicing a mortgage and credit card debt. Borrowers have less money to spend on consumption because more of their income is being use for interest payments.

The prices of assets may fall, reducing personal wealth and therefore reduces consumption. The falling assets prices also reduce consumer confidence, further deflating consumption.

The opposite is of course true for expansionary interest rates.

Question 23

How do contractionary interest rates reducing business investment decrease AD?

Answer 23

Businesses will postpone or cancel investment projects because the higher borrowing costs may make the purchase of capital goods unprofitable. This will be exacerabated by falling business confidence.

The opposite is of course true for expansionary interest rates.

Question 24

How do contractionary interest rates affecting imports and exports via the exchange rate decrease AD?

Answer 24

A higher rate of interest increases the demand for pounds by attracting capital flows into the currency. This causes the pound’s exchange rate to rise, making UK exports less price competitive in world markets and imports more competitive in UK markets. The BoP worsens, and AD falls.

The opposite is of course true for expansionary interest rates.

Question 25

What is expansionary monetary policy?

Answer 25

Uses lower interest rates to increase AD and shift the AD curve right.

Question 26

Draw a graph of the effects of expansionary monetary policy.

Answer 26

Question 27

What is the transmission mechanism of interest rate policy?

Answer 27

Question 28

What is the estimated time lag between a change in bank rate and rate of inflation?

Answer 28

Up to two years.

Question 29

What is conventionary monetary policy?

Answer 29

Adjusting the bank rate to manage levels of AD.

Question 30

When did conventional monetary policy stop working?

Answer 30

During the 2008 financial crisis.

Question 31

Why may conventional monetary policy not work during a recession?

Answer 31

• The zero lower bound
• The liquidity trap

Question 32

Why may the zero lower bound prevent conventional monetary policy from working during a recession?

Answer 32

If interest rates reach 0%, there comes a point at which a floor is reached. This is called the ZLB and once this is reached, it becomes impossible (in the BoE’s view) to cut bank rate any further so conventional monetary policy stops being useful.

Question 33

Why may the liquidity trap prevent conventional monetary policy from working during a recession?

Answer 33

It is often the case in a deep recession, that no matter how low interest rates are set, consumers refuse to borrow and banks refuse to lend.

This causes spending in the economy to fall.

Question 34

What is quantitative easing?

Answer 34

When the BoE buys assets, usually government bonds, with money that the bank has created electronically.

Question 35

What is the main form of unconventional monetary policy?

Answer 35

Quantitative easing.

Question 36

What is the hope with quantitative easing?

Answer 36

Financial institutions which sell bonds to the BoE and lend the newly created money to businesses and individuals.

Question 37

How does quantitative easing work?

Answer 37

QE directly increases the money supply.

The money is held in bank deposits, with commercial banks holding more deposits at the BoE which increases the commercial banks’ ability to lend to the general public.

Question 38

What were the three initial bouts of QE, and what was the value of each?

Answer 38

QE1 (£200 billion)
QE2 (£75 billion)
QE3 (£100 billion)

Question 39

When was QE first employed in the UK?

Answer 39

2009 to address the recession.

Question 40

When was QE employed again?

Answer 40

In 2016 to address Brexit concerns.

£60 billion of government bonds and £10 billion of private sector corporate bonds.

Question 41

What can the BoE do if it wants to ‘unwind’ QE?

Answer 41

They can sell some of the bonds back to the public which would reduce AD in the economy.

Question 42

Has QE been successful?

Answer 42

QE1 has been argued to be successful. It prevented the ‘08-‘09 recession from developing to a depression.
QE2 and QE3 did very little, as growth rates in the UK flat-lined from 2010 onward. In 2013, when the economy did pick up, there was no further QE bouts.

Question 43

What is forward guidance?

Answer 43

Attempts to send signals to financial markets, businesses and individuals about the BoE interest rate policy in the months and years ahead, so that economic agents are not surprised by a sudden and unexpected change in policy.

Question 44

How has forward guidance come under scrutiny?

Answer 44

It requires accurate economic forecasting, which can often be wrong.

• In 2014, the Bank said they would not increase the bank rate unless unemployment fell below 7%. They predicted unemployment would fall to below 7% in 2016, but it came much faster and yet the bank did not increase the bank rate.

There are three main issues:
* The strategy could be knocked off course by an economic shock (as seen above)
* Financial markets may form their own expectations and ignore the BoE predictions.
* Credibility can be lost if the BoE keeps ‘changing the goal posts’.

Question 45

What is the relationship between changes in interest rates and the exchange rate?

Answer 45

A fall in UK interest rates causes financial capital to flow out of the pound and into other currencies in search of better rates of return.

This reduces the demand for pounds and increases the supply of pounds on the forex market, causing the value to fall.

The opposite is true for higher UK interest rates.

Question 46

What happens when the exchange rate of the pound falls?

Answer 46

• The value of imports increases. This increases the rate of inflation in the UK due to import-cost-push inflation.
• The value of exports decreases. This increases the demand for UK exports and adds to demand-pull inflationary pressures. This is likely to improve the BoP.