4.4.3 Role Of Central Banks Flashcards
1
Q
Govt. intervention for financial market failure?
A
Monetary policy - demand side policy
2
Q
What is the target of monetary policy?
A
- aim to achieve a target rate of inflation 2% +/- 1%
- aim linked to growth + employment
- eurozone target is asymmetrical = must not exceed 2%
3
Q
Why announce inflationary targets?
A
- to influence expectations
- if economic agents know that the target rate of inflation is 2% then firms know they have to keep costs under control
- workers know they need to be realistic with wage demands
- low inflation is key for macroeconomic stability which is crucial for investment + growth = imposes a discipline on economic agents
4
Q
Has the Bank of England met its target?
A
- no = very difficult to control inflation in a global economic environment
- there are domestic + external factors e.g. financial crisis, brexit, Covid, Russia + Ukraine
5
Q
Impact of external factors on inflation?
A
- brexit = administration costs, border checks, fall in value of pound
- Covid = supply chains, suppressed demand
- post Covid = demand pull inflation
- invasion of Ukraine = oil + gas prices
6
Q
What is the monetary policy committee strategy?
A
- MPC has decided to aim to hit target rate of inflation gradually rather than quickly as this could be too volatile for the economy as a whole for unemployment + growth (e.g. domestic costs would increase)
- this means interest rates/bank rate are changed by 0.25% at a time
- the MPC have an overall consideration for the economy e.g. growth + unemployment + not just inflation
7
Q
What is a transmission mechanism?
A
- the process by which a change in interest rates affects aggregate demand + inflation
- main instrument is the bank rate
8
Q
How does the transmission mechanism work?
A
- the bank rate affects rates set by mortgage lenders, financial institutions + commercial banks
- lower interest rate stimulates AD + higher interest rate reduces AD
- lower interest rate will (other things being equal) increase asset prices e.g. bonds
- interest rates can be used to stimulate the exchange rate to reduce cost push pressure
9
Q
Impact of an increase in interest rates?
A
- fall in consumption due to higher costs of borrowing e.g. higher mortgage repayments on flexible rate mortgages, higher savings
- lower investment as higher costs of borrowing may make some investment projects less profitable
- govts. will pay more on debt interest
10
Q
Impact of increase in interest rate on the exchange rate?
A
- increase in hot money will lead to an appreciation of the pound
- increases in interest rates leads to an inflow of hot money, increasing the demand for the currency (pound)
- imports are cheaper, exports are more expensive
- Marshall Lerner condition (J-curve)
11
Q
Impact of an increase in interest rates on income inequality?
A
- the distribution of income becomes less equal as it is presumed only higher income groups have higher levels of savings + they will gain
- lower income groups have loans, which may be affected by higher interest rates
12
Q
How effective was monetary policy in response to the financial crisis?
A
MPC lowered interest rates to 0.5% in March 2009, but it was ineffective because:
- banks were/are more cautious about lending so loans have fallen haven being hit hard by the credit crunch
- less confidence in the economy so less demand for loans from businesses + customers
- banks have not always passed on the lower interest rates to customers
Since lower interest rates didn’t work quantitive easing was used as there was not much room for any further cuts
13
Q
Disadvantages of monetary policy?
A
- time lags = impact takes 18 months
- interest rate PED inelastic loans = as interest rates increase demand falls by a small percentage = monetary policy is less effective
- failure of banks passing on cuts in interest rates to customers after cuts in the bank rate (repo rate) by MPC
- quantitative easing limited success as banks not willing to lend after major losses from credit crunch
- side effects = interest rates hit homeowners (especially those on variable rates), investment + exporters (through impact on exchange rate)
14
Q
What does the MPC consider before deciding on interest rates?
A
- financial markets e.g. share prices
- international economy e.g. growth of BRIC = more globalised world makes it much harder for MPC to control inflation
- money + credit
- demand + output = AD + AS, estimates of size of output gap, looking at AD components
- labour market = employment/ unemployment, wage rates, the number of unemployed to number of vacancies (indicator of spare capacity)
- cost + prices e.g. price of oil, commodities (indicator of cost push pressures)
15
Q
What is quantitative easing?
A
- type of expansionary monetary policy
- involves the govt buying bonds from banks/financial institutions = banks have more cash that they can then lend out to firms or individuals
- this stimulates the economy = increases AD
16
Q
Impact of QE on interest rates?
A
- Bank of England buys bonds from banks
- increase demand for bonds = increase market price of bonds
- inverse relationship between bond prices + interest rates = so interest rate goes down
- this encourages firms + consumers to borrow
17
Q
What is asset sales?
A
- opposite of quantitative easing
- asset sales (sell bonds) by the Bank of England reduces the money supply
18
Q
What are govt bonds often called?
A
Gilts
19
Q
Banker to government
A
- central banks perform various banking services such as handling accounts of government departments + making short term advances to the govt
- the Bank handles govt spending, taxation revenue, borrowing + lending
20
Q
What is bond yields?
A
- the interest rate on a bond + the yield will vary inversely with the market price of a bond
- when bond prices are rising, the yield will fall
- when bond prices are falling, the yield will rise
21
Q
Banker to banks
A
- commercial or high street banks hold deposits at the Bank of England
- commercial banks hold reserve balances + cash ratio deposits at the Bank of England
- reserve balances act as a stock of liquid assets = perform a clearing function e.g. settle any daily imbalances in transaction between the banks
22
Q
Lender of last resort
A
- if a bank runs into liquidity problem, they may be able to borrow direct from the central bank
- this aims to ensure financial stability + avert a financial crisis
23
Q
What is a liquidity crisis?
A
- when a commercial bank has insufficient short-term assets to meet short term liabilities
- the central bank will intervene if it fear systemic risk
- systemic risk = possibility an event at the company/bank level could trigger severe instability or collapse an entire industry or economy —> major contributor to the financial crisis 2008
24
Q
What does a lender of last resort prevent?
A
- a bank run
- this is when a large number of customers withdraw their deposits from a bank at the same time, usually because of fears that a bank is or will become insolvent
- customers generally request cash + may put the money into govt bonds or other institutions they believe to be safer
- a bank run could collapse the financial sector
25
When will the Bank of England not intervene as a lender of last resort?
- if it thinks a particular bank had made bad decisions + has a liquidity crisis which will not bring other banks down
- Bank of England will aim to avert systemic risk but not the risk to an individual bank
26
What is the role of regulation?
- aimed at reducing reckless bank lending = banks need to be more prudent
- to provide assurance to customers their money is safe
- that financial institutions are regulated for their conduct, so they don’t behave unethically
- reduce systemic risk = banks will be allowed to fail if it doesn’t lead to systemic risk
27
Forms of new regulation?
- banks hold a greater proportion of their assets in chase to prevent liquidity crisis (capital ratio) = a higher capital ratio increases customer confidence + reduces likelihood of a bank run
- banks had to separate retail (commercial high street banking operations) + investment banking activities
- regulators check for systemic risk —> stress tests are used to check the position of banks if certain scenarios happened to ensure they have enough cash
- bonuses for investment bank managers capped (reduces moral hazard)
- regulators check providers are not taking advantage of asymmetric info + exploit customers e.g. sale of PPI
28
What are the three regulatory bodies?
- FPC (financial policy committee) = part of the Bank of England
- PRA (prudential regulation authority) = part of the Bank of England
- FCA (financial conduct authority) = report to treasury + parliament
29
Role of the financial policy committee
- responsible for contributing to the bank’s financial stability objective by identifying + monitoring systemic threats to financial stability
- it has the power to take action to reduce or remove those threats e.g. of risk could be unsustainable levels of debt
-
30
How does the FPC act when it identifies a risk?
- it can use its power of direction or its power of recommendation
- it’s directions are binding instructions it can give to the PRA + FCA = it can issue a direction to the PRA to make banks, building societies + large investment firms carry out certain actions
- it can also make recommendations = can make recommendations on a ‘comply or explain’ basis to the PRA + FCA —> this means if the regulators decide not to implement a comply or explain recommendation they must explain publicly their reasons
31
What is the role of the PRA?
- sets standards + supervises financial institutions at the level of the individual firm
- role defined by three statutory objectives: promote safety + soundness of firms, to contribute to the provision of an appropriate degree of protection (specifically for insurers), facilitate effective competition
32
How does the PRA act?
- uses judgement to focus its work on those firms + activities posing the greatest risks to financial system + to policyholders
- uses stress testing to assess the soundness of firms against risks
- PRA works with firms to minimise these risks - but that doesn’t meant a firm won’t be allowed to fail
- in the worst case scenario the PRA works with the Bank of England to ensure that a bank can fail without disrupting the supply of key financial services
33
What is the role of the FCA?
- oversees the conduct of banks + financial organisations
- reports to the treasury + parliament
- protects consumers
- protects the integrity of the financial system
- promotes competition in the commercial bank market e.g. by preventing market rigging
34
What is macro prudential policy?
- means an approach to reduce systemic risk
- the FPC monitors risk to the entire financial system as whole
- this involves internal e.g. housing crisis + external factors that could lead to instability e.g. global financial markets
35
What is micro prudential policy?
- means ensuring that individual banks + financial institutions have balance sheets that are robust to shocks
- regulation of individual financial businesses
- this is covered by the work of the PRA (who is also a member of the Bank of England)
36
Current inflation data
- Jan 2025 - 3%
- Feb quarterly report Bank of England suggested inflation would rise up to 3.7% by the end of summer
37
Conclusion for monetary policy
- in an increasingly interconnected global economy it is unlikely monetary policy in the form of interest rate changes in the UK can control inflation + keep it within the target rate
- external influences on inflation are difficult to control + while interest rate increases can help to reduce AD they often only work after an 18 month lag
- monetary policy has urs place but to rely on it solely to reduce inflation may be misguided
- in conjunction with monetary policy an economy would benefit from strong supply side policies + flexible labour market to maintain low inflation (wage inflation)
38
Evaluation of regulation
- assyemtric info - bank may know more than the regulator
- regulatory capture - regulator may work too closely with the bank + see things from the banks perspective
