4.2.4.3: Central Banks And Monetary Policy Flashcards
What are the functions of a central bank?
The central bank manages the currency, money supply and interest rates in an economy. For example, the Bank of England (BoE) is a central bank.
Central banks issue physical cash (notes and coins) securely and use methods to prevent forgery. This is so people trust the money. The central bank can regulate bank lending to ensure there is stability in the financial system.
- also acts as a banker to the gov - e.g. making payments on behalf of the gov, also manages public debt and issues public loans
- also the banker to the banks - lender of last resorts. - if a bank is at risk of collapsing, the bank might lend to them when they have no other way.
What is the MPC (Monetary Policy Committee)
In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They are independent from the government, and consist of 9 members who meet 8 times a year to discuss what the rate of interest should be.
Interest rates are used to help meet the government target of price stability and a 2% inflation rate, since it alters the cost of borrowing and reward for saving. The objective of monetary policy, to achieve price stability.
- The bank controls the base rate, defined as the interest rate set by central banks for lending to other banks. This is used as a benchmark for interest rates set by commercial banks.
What is monetary policy?
Monetary policy involves using interest rate and other monetary tools (money supply and exchange rates) to influence the levels of consumer spending and AD
How does the Bank of England use inflationary trends?
- if they expect higher inflation and higher growth, they will tend to increase interest rates, which is referred to as deflationary (or tight) monetary policy)
- if they expect lower growth and a fall in the inflation rate, they will tend to cut interest rates, which is referred to as expansionary (or loose) monetary policy.
What is the current interest rate?
4.5% - been going up recently
What is the expansionary monetary policy?
- expect low inflation and growth (e.g. trying to recover from a recession), the MPC will either reduce interest rates, increase money supply or devaluing the currency.
- a decrease in the interest rates will decrease the cost of borrowing, meaning firms can go ahead with their planned investments as loans are cheaper. Also, consumers are more willing to take out personal loans or spend on credit cards. However, it will decrease the reward for saving, so will spend more - increasing consumption. As investment and consumption are components of AD, this will cause AD to increase - represented by a shift right on the curve.
What is deflationary monetary policy?
- when high inflation is expected, MPC may have to increase interest rates, lower the money supply or increase the value of the currency.
- increasing interest rates will increase cost of borrowing, affecting firms as they will delay their planned investment due to loans being more expensive. This will also affect consumers as they will be less likely to take out personal loans or spend on a credit card. It also increases reward for saving, so people will save instead of spend - decreasing consumption. As investment and consumption are components of AD, AD with therefore also decrease - shifting left on the diagram.
What are the factors considered by the MPC when setting the bank rate?
—> unemployment rate - if unemployment is high, spending is likely to fall - suggests MPC will drop IR to encourage more spending
—> Savings rate - a lot of saving means less spending - IR might fall
—> Consumer spending - if high levels of spending, there could be inflationary pressures on the price level - MPC will increase IR
—> High Commodity prices - since the UK is a net importer of oil, a high price could lead to cost push inflation - MPC will increase IR to overcome the inflationary pressure
—> Exchange rates - A weak pound would cause the average prove level to increase. This makes UK exports relatively cheap, so UK exports increase.
How do changes in the exchange rate affect AD
A reduction in the exchange rate causes exports to become cheaper, which increases exports. This assumes that demand for exports is price elastic. It also causes imports to become relatively expensive. This means the UK current account deficit would improve.
o However, this is inflationary due to the increase in the price of imported raw materials. Production costs for firms increase, which causes cost-push inflation.
How does interest rates affect the currency?
An increase in interest rates, relative to other countries, makes it more attractive to invest funds in the country because the rate of return on investment is higher. This increases demand for the currency, causing an appreciation. This is known as hot money.
- vice versa
What is the transmission mechanism?
When the central bank changes interest rates, there are many channels through which this will work through before having a final effect on the real economy. There will be a time lag before inflation is controlled. Interest rate changes have to ‘feed through’ the transmission mechanism and this can take up to 24 months before the full impact is seen.
What is quantitive easing (QE)?
QE is a method to pump money directly into the economy. When interest rates are already very low, it is not possible to lower them much more. The bank buys assets in the form of gov bonds using the money they have created. Then used to buy bonds from investors, which increases the amount of cash flowing in the financial system. This encourages more lending to firms and individuals, since it makes the cost of borrowing lower. This should encourage more investment, more spending, and hopefully higher growth. A possible effect of this is that there could be higher inflation.
What is funding for lending?
E.g. worsening conditions in the Euro area meant that UK banks faced higher funding costs. In order to support them, the government introduced the Funding for Lending Scheme, which aimed to lower these costs and provide cheap funding to banks and building societies.
What is Forward Guidance?
This is used by central banks to detail what the future monetary policy will be. This is with the intention of reducing uncertainty in markets. For example, the MPC might state they will keep the interest rate at a certain level until a specified date.
