4.3 Central Banks And Monetary Policy

Question 1

What are the functions of a central bank?

Answer 1

• to maintain financial stability

- to help the government maintain macroeconomic stability

Question 2

Central bank definition

Answer 2

The bank of an economy responsible for issue of money and management of monetary policy for that currency

Question 3

How does the central bank create financial stability

Answer 3

It acts as the ‘lender of last resort’ to the banking sector
Also provides liquidity insurance

Question 4

What is liquidity insurance?

Answer 4

The central bank will make available liquid assets for banks that need access to those funds

Question 5

How does the central bank achieve macroeconomic stability?

Answer 5

The bank of England’s objective is to achieve price stability. They influence the money supply and set interest rates, to meet an inflation target

Question 6

Why might the central banks role of a lender of last resort be potentially bad?

Answer 6

• moral hazard
• regulatory capture = banks can ask the BoE to lend at a lower interest rate
• banks may not hold any liquidity as they know they can go to the BoE if they need it = riskier as they hold funds in other ways such as bonds or shares to gain more profit

Question 7

What is moral hazard in terms of the central bank?

Answer 7

The central bank promotes moral hazard as banks may know that if a risk is taken that doesn’t pay off they can be bailed out by the Bank of England by providing liquidity

Question 8

Monetary policy definition

Answer 8

Changes to interest rates, the money supply and the exchange rate by the central bank in order to achieve economic policy objectives

Question 9

What is the key objective of monetary policy?

Answer 9

To achieve the governments Inflation target

Question 10

What is the UKs inflation target

Answer 10

2% (plus or minus 1%)

Question 11

What is the bank rate?

Answer 11

The interest rate set by the Bank of England that affects the interest rates set by banks and other financial institutions across the economy

Question 12

What are the two types of monetary policy?

Answer 12

Expansionary or contractionary

Question 13

Why would a central bank use expansionary monetary policy?

Answer 13

• boost AD to increase inflation
• increase growth
• reduce unemployment

Question 14

Why would the central bank use contractionary monetary policy?

Answer 14

• reduce AD to decrease inflation
• to prevent asset or credit bubbles
• promotes sustainable growth = if growth is fuelled by debt, this can lead to unsustained growth
• reduce account deficit

Question 15

What are asset and credit bubbles?

Answer 15

Asset bubble e.g house prices, if house prices are rising to high or credit bubbles e.g to much borrowing, there is fear of a financial crash, whereby people cannot pay back their debt

Question 16

Who are the MPC and what do they do?

Answer 16

They are the monetary policy committee of the BoE (nine memebers) who set the level of interest rates through setting the bank rate

Question 17

How does expansionary monetary policy work?

Answer 17

• interest rates are lowered
• borrowing is more desirable = greater return
• saving is less desirable = less return
• variable mortgages rates are reduced
• all leads to more consumption = AD increases
• rates on business loans fall = more investment
• weaker exchange rate through hot money = more exports = AD increases

Question 18

What is hot money?

Answer 18

Occurs when individuals move money out of a country to another to exploit a relatively higher interest rate = better return on the money

Question 19

What are the negatives of a higher interest rate on the rest of the economy?

Answer 19

• higher unemployment cause by lack of spending
• growth of the economic is reduced (LRAS) because of lower investment
• lower tax revenue (Lower spending = less VAT)
• reduces level of exports due to a rise in the exchange rate

Question 20

How does higher interest rates lead to rise in the exchange rate?

Answer 20

• better return on Money stores in Uk banks = hot money flows in
• leads to higher demand for British pounds
• leads to an appreciation in the value of the pound
• leads to a rise is the exchange rate as pound is stronger making imports cheaper and exports dear

Question 21

Limitations of interest rates in controlling the economy

Answer 21

• less useful in controlling rises in cost-push inflation
• time lags in their effectiveness
• uncertain effects = not sure how people will react
• changes may have to be large to have any significant effect
• may not have a huge impact on the exchange rate as depend on the UKs relative interest rate to foreign countries
• interest rates cannot fall below 0

Question 22

Example of cost-push inflation and interest rates not working

Answer 22

In 2012, uk inflation reached 5% (well above its target) due to cost-push factors
MPC didn’t opt to raise interest rates as it was felt they would have little impact on the inflation rate

Question 23

Transmission mechanism definition

Answer 23

How a change in monetary policy decisions work its way through the economy to affect macroeconomic indicators

Question 24

How does changes to the bank rate influence market rates

Answer 24

• financial institutions copy the change in the bank rate
• this affects borrowers (both businesses and consumers) and savers
• influences variable mortgage interest rates

Question 25

What does changes to the bank rate affect first

Answer 25

• market rates
• asset prices
• expectations/confidence
• exchange rate

Question 26

How does a change in the bank rate affect asset prices?

Answer 26

• as market rates follow the change in bank rate e.g bank rate is cut = mortgage interest rates cut = higher demand for assets such as houses = higher house prices

Question 27

How does a change in bank rate affect expectations/confidence?

Answer 27

• if asset prices are rising because of lower interest rates increasing demand for mortgage and therefore house = asset prices rise
• this leads to higher consumer confidence as there asset is worth more = wealth effect = confidence
• changes in bank rate may effect expectations of the future as people know that cuts in interest rates lead to e.g investment = employment (and vice versa)

Question 28

What will the first four impacts of changes in the bank rate influence?

Answer 28

domestic demand and net external demand

Question 29

What does exchange rate influence in the monetary policy transmission mechanism?

Answer 29

Import prices

Question 30

What is the last thing impacted upon in the monetary policy transmission mechanism?

Answer 30

Inflation

Question 31

What does domestic demand and net external demand impact in the monetary policy transmission model?

Answer 31

domestic D + net external D = total demand

• this impacts domestic inflationary pressure
• which ends up impacting inflation

Question 32

How does the BoE impact the money supply and the amount of credit?

Answer 32

• Quantitive easing
• funding for lending scheme
• forward guidance

Question 33

Quantitive easing definition

Answer 33

The buying of government bonds from financial institutions with created money by the central bank so as to increase the money supply and liquidity in the economy

Question 34

How does QE increase the money supply and encourage borrowing?

Answer 34

• central bank electronically creates money
• They buy government bonds from financial institutions
• financial institutions with this new cash = loan out money or invest to increase profit (shares or bonds)
• this helps businesses issuing the bonds and shares which should stimulate spending in the economy

Question 35

Detailed explanation of why if financial institutions buy bonds or shares through QE, it impacts borrowing

Answer 35

• buy bonds or shares to increase profit
• increased D for bonds = price of bonds increases = fall in yield of bonds
• if yield of bonds fall = cheaper to borrow (issue bonds) as less money is paid out as interest = increase in borrowing = increase in spending
  Or shares
• investment in shares creates the wealth effect = increase in spending

Question 36

Forward guidance definition

Answer 36

Announcements made by the central bank as to the likely future direction of monetary policy in advance of actual changes

Question 37

How does forward guidance work?

Answer 37

It is meant to provide the private sector to make borrowing and spending decisions with greater confidence

Question 38

Factors the MPC take into account when setting the bank rate

Answer 38

• consumer spending
• exchange rate
• high commodity prices
• unemployment rate
• savings ratio