4.3 Central Banks & Monetary Policy

Question 1

Definition & Aim of Monetary Policy

Answer 1

• Monetary policy is used to control the money flow of the economy/aims to influence AD
• Done with interest rates and quantitative easing
• Is conducted by the Bank of England, which is independent from the government.

Question 2

What are the types of monetary policy?

Answer 2

• Expansionary-aims to INCREASE AD
  -Increase inflation, Increase growth, Reduce unemployment
• Contractionary-aims to DECREASE AD
  -Reduce inflation, Prevent asset/credit bubbles, Reduce excessive debit and promote savings, Reduce the CAD

Question 3

Role of Central Banks?

Answer 3

• The central bank manages the currency, money supply and interest rates in an economy.
• Central banks issue physical cash (notes and coins) securely and using methods to prevent forgery-(so people trust the money).
• They can regulate bank lending to ensure there is stability in the financial system.

Question 4

Functions of the Central Bank

Answer 4

• Implementation of monetary policy
• Banker to the government
• Banker to the banks/lender of a last resort

Question 5

How does the Central bank Implement the monetary policy?

Answer 5

• In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money.
• They are independent from the government, and the nine members meet each month to discuss what the rate of interest should be.
• Interest rates- uses to help meet government target of price stability (since it alters the cost of borrowing and reward for saving).
• The bank controls the base rate, which ultimately controls the interest rates across
  the economy.

Question 6

How is the Central bank a Banker to the government?

Answer 6

• The central bank provides services to the Central Government.
• It collects payments and makes payments on behalf of the government.
• It maintains and operates deposit accounts of the government.
• Also manages public debt and issues loans.

Question 7

How is the Central bank the lender of a last resort?

Answer 7

• If there is no other method to increase the supply of liquidity when it is low, the Bank of England will lend money to increase the supply.
• If an institution is risky or is close to collapsing, the Bank might lend to them-(when they have no other way to borrow money).
• It can protect individuals who deposit funds in a bank and might otherwise lose them.
• It aims to prevent a ‘run on the bank’, which is when consumers withdraw their bank deposits in a panic, because they believe the bank will fail.
• Usually, banks will avoid borrowing from the lender of last resort, because it is suggests the bank is experiencing a financial disaster.

Question 8

Monetary policy instruments

Answer 8

• Interest rates
• Asset purchases to increase the money supply: Quantitative Easing (QE)
• Funding for lending
• Forward guidance

Question 9

Interest Rates: Expansionary effects/Benefits

Answer 9

• When interest rates are low, the reward for saving is low and the cost of borrowing is cheaper-this means consumers and firms can access credit cheaply
• This leads to an increase in consumption and investment in the economy, stimulating AD and boosting growth
• Lower mortgage rates encourage consumer spending, boosting AD and stimulating growth.
• A weaker exchange rate can boost (x-m), stimulating AD
• This is usually used during periods of low inflation.
• However, during the financial crisis, the UK interest rate fell to a historic low of 0.5%, and has been at this rate since March 2009.
• Despite high inflation, the interest rate was set at a low rate to stimulate AD and boost economic growth.

Question 10

What are the cons of expansionary monetary policy (reducing interest rates)?

Answer 10

• Higher demand-pull inflation
• Current Account Deficit-higher spending on imports (trade off)
• Liquidity trap-interest rates have a lower bound (keynesian; after a certain point interest rates wont be effective)
• Negative impact on savers
• Time lags associated

Question 11

Interest rates: Contractionary effects/Benefits

Answer 11

• When interest rates are high, the reward for saving is high and the cost of borrowing is higher-this encourages consumers to save more and spend less and is used during periods of high inflation.
• This leads to lower consumption and investment, therefore reducing AD and economic growth
• Lower demand pull inflation
• Reduces CAD
• More sustainable borrowing/lending

Question 12

What are the cons of contractionary fiscal policy (raising interest rates)?

Answer 12

• Lower growth
• Higher cyclical unemployment (demand side shock)
• Reduces consumption and investment-increases the cost of borrowing so its bad for LRAS and growth
• Worsening CAD via exchange rate strengthening

Question 13

Asset purchases to increase the money supply: Quantitative Easing (QE)

Answer 13

• Used by banks to help to stimulate the economy when standard monetary policy is no longer effective.
• Has inflationary effects since it increases the money supply, and it can reduce the value of the currency.
• QE is usually used where inflation is low and it is not possible to lower interest rates further.
• QE is a method to pump money directly into the economy-it has been used by the European Central Bank to help stimulate the economy.
• The bank bought assets in the form of government bonds using the money they have created-this is 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.
• The theory is that this encourages more investment, more spending, and hopefully higher growth. A possible effect of this is that there could be higher inflation.
• If inflation gets high, the Bank of England can reduce the supply of money in the economy by selling their assets-this reduces the amount of spending in the economy.

Question 14

Funding for lending

Answer 14

• 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-(aimed to lower these costs and provide cheap funding to banks and building societies).

Question 15

Forward Guidance

Answer 15

• Used by central banks to detail what the future monetary policy will be 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.

Question 16

Factors considered by the MPC when setting bank rate

Answer 16

• Unemployment rate: if unemployment is high, consumer spending is likely to fall-suggests the MPC will drop interest rates to encourage more spending.
• Savings rate: if there is a lot of saving, consumers are not spending as much-interest rates might fall.
• Consumer spending: if there is a high level of spending in the economy, there could be inflationary pressures on the price level- would cause the MPC to increase interest rates.
• High commodity prices: Since the UK is a net importer of oil, a high price could lead to cost-push inflation-could push the MPC to increase interest rates to overcome this inflationary pressure.
• Exchange rate: A weak pound would cause the average price level to increase-makes UK exports relatively cheap, so UK exports increase.
• Since imports become relatively more expensive, there would be an increase in net exports. The MPC might consider increasing the interest rate.

Question 17

How changes in the exchange rate affect AD and the macroeconomic policy objectives:

Answer 17

• A reduction in the exchange rate causes exports to become cheaper, which increases exports-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.
• 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.
• 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-increases demand for the currency, causing an appreciation. This is known as hot money.

Question 18

Evaluation of monetary policy

Answer 18

• Size of the output gap
• Consumer confidence
• Business confidence
• Banks willingness to lend/pass on the full cut
• Size of the rate cut