4.2.4 Financial Markets + Monetary Policy

Question 1

Define Monetary Policy.

Answer 1

• Monetary Policy: changes to interest rates, the money supply + the exchange rate, by central bank in order to influence AD.
• Primary role is to control inflation (2% inflation target).

Question 2

Define Expansionary Monetary Policy.

Answer 2

Policies to increase AD.

Question 3

State why Expansionary Monetary Policy is used.

Answer 3

• Increase inflation: boost AD, raise demand-pull inflation- if inflation rate is below target
• Increase economic growth
• Reduce unemployment

Question 4

Explain what the Monetary Policy Transmission Mechanism is why it is used.

Answer 4

Knock on effect of reducing interest rates to boost AD.

• Reduce credit card interest rates: borrowing for consumers- increases MPC- more likely to spend on big ticket items (e.g. cars), thus AD boosts as C rises.
• Decrease in S rates: as interest on saving accounts falls, reduces incentive to save, increase incentive to spend.
• Decrease in mortgage rates: households pay less mortgage payments, increases their disposable income + increases their MPC.
• Decrease rates on business loans: increases incentive for business to borrow + increases I.
• Weaker exchange rate:** increases (X-M)

Question 5

Explain the effects of Expansionary Monetary Policy on LRAS.

Answer 5

• As interest rates on business loans decrease, + I increases
• I boosts LRAS, due to increase in the quantity of capital, increase in the quality of capital,+ an increase in the productive efficiency of economy.

Question 6

State + explain the problems with Expansionary Monetary Policy.

Answer 6

• Demand-Pull Inflation: too much AD in the economy may lead to demand-pull inflation.
• Current Account Deficit: lower interest rates that stimulate AD, may widen the current account deficit, due to there being more growth in economy, incomes rise + households will spend more of their income on imports.
• Negative Impact on Savers: when interest rates fall, the rate of interest rates fall. If inflation is higher than the nominal interest rates in the economy, then the real returns on savings could be negative- rate of return is less than the rise of prices.
• Time Lags: takes a long time for an interest rate cut to fully feed through the different channels of the transmission mechanism, + to boost AD fully (18 months- 2 years).

Question 7

Evaluate the use of Expansionary Monetary Policy.

Answer 7

• Size of the Output Gap: if economy is already very close to full employment, with a very small negative output gap, then any cut in i.r. may boost AD but we wont see much reduction in unemployment rates, instead its likely to see inflation overshooting the target.
• Consumer Confidence: need to be confident in their job prospects, in order to borrow + consume when interest rates are lower.
• Business Confidence: need to be confident in the future state of the economy, in demand+ profitability for their business, if they’re going to borrow + invest.
• Banks Willingness to Lend/Pass On the Full Cut: may not be willing to lend if there’s a banking crisis/financial sector crisis in the economy, then may haud cash instead of lending at lower interest rates- renders expansionary monetary policy completely useless + if central banks cut the interest rate, will banks follow with the same rate, if they don’t we wont see the boost in Ad in which we want to see.
• Size of the Rate Cut: if we want expansionary monetary policy to really boost AD, then a big cut is more desirable, makes it much cheaper for consumers + firms to borrow- incentivises borrowing, promotes C + I

Question 8

Define Contractionary Monetary Policy.

Answer 8

Policies to decrease AD.

Question 9

State + explain why Contractionary Monetary Policy is used.

Answer 9

• Reduce inflation: reduce AD
• Prevent asset/credit bubbles: i.e. prevent excessive growth of house prices + prevent excess credit borrowing by households + businesses
• Reduce excess debt + promote S: if economic growth in economy is very debt fuelled, then higher interest rates reduce the incentive to take out so much debt, thus more sustainable growth is promoted.
• Reduce current account deficit: consequently by reducing AD, because as AD falls, growth falls, incomes fall, therefore less spending on imports.

Question 10

State + explain the benefits of Contractionary Monetary Policy, via higher interest rates.

Answer 10

• Reduction in Inflation (demand-pull)
• Discourage Household/Corporate Debt: takes away pressure on banking sector- reducing the chance of bank failure + systemic risk, reducing risks of recession.
• More sustainable Borrowing + Lending: only those who need to borrow + can afford to borrow at higher interest rates enter the market. Less likely to get asset price bubbles- less chance of bubbles, less chance of recession.
• Encourage Saving: those living of their savings (i.e. pensioners) are likely to see a rise in living standards, those saving to reach financial goals are able to reach them faster. Also a safety net for households/business getting into financial difficulty.
• More Affordable Housing: by increasing the cost of mortgages, can cool down demand for housing- helps lower the price.
• Reduce CA Deficit: reducing incomes, can lower spending on M.
• Flexibility for Expansionary Monetary Policy: now have space for i.r. cuts in the next financial crisis/recession.

Question 11

State + explain the problems with Contractionary Monetary Policy, via higher interest rates.

Answer 11

• Lower Growth + Higher Unemployment (Cyclical): demand-side shock by raising i.r. may lead to a recession
• Impact on the Indebted: if i.r. goes up + its more expensive to service debt/repay loans, for households it may mean bankruptcy + homelessness, if businesses can’t afford to pay loans it may mean business bankruptcy + higher unemployment
• Reduces Investment: by increasing the cost of borrowing, takes away incentive for businesses to borrow + fund their investment projects, bad for SR + LR growth.
• Worsen CA Deficit via Exchange Rate Strengthening: ’ hot money inflows’ savings that chase the best i.r. internationally. Thus, if the UK has the highest i.r. savings from abroad will flood into UK financial institutions, increasing D for £, strengthening the value of £. M become cheaper X becomes more expensive-links to a worsened CA Deficit.