5.3 Monetary policy Flashcards
What is Monetary policy?
It is done by changes to interest rates, the money supply and the exchange rate by the central bank in order to influence AD. This is done with interest rates and quantitative easing.
Hoe do banks use interest rates?
In the UK, the MPC alters the interest rates to control the supply of money. The bank controls the base rate, which ultimately controls the interest rates across the economy.
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 it is used during periods of high inflation.
When interest rates are low, the reward for saving is low and the cost of borrowing is low. This means consumers and firms can access credit cheaply which encourages spending and investment.
How do banks purchase assets to increase the money supply? QE
This is used by banks when monetary policy is no longer effective. It is inflationary since it increases the money supply and can reduce the value of the currency. QE is usually used when inflation is low and it is not possible to lower interest rates further.
The bank buys assets in the form of gov bonds using money they have created. This is then used to buy binds from investors which increases the amount of clashing 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 it encourages more investment, more spending and hopefully higher growth. A possible effect of this is that there could be higher inflation
What is expansionary monetary policy? (INCREASE IN AD) what are the reasons to use it?
Increase AD and raise demand pull inflation. Also increase growth and reduce unemployment
Reducing credit card interest rates which makes borrowing cheaper for consumers. This increases the marginal propensity to consume. Spend more on big ticket items and AD boosts as consumption rises
Reducing savings rate which increases consumption. Reduces incentive to save and increases incentive to spend instead
Reducing mortgage rates means disposable incomes increase so consumption increases. For variable rate mortgages these IR will follow central bank rates which means households paying less monthly to mortgage payments
Lower interest rates on business loans increases incentive to borrow which allows them to invest and boost AD
A weaker exchange rate means savers have less incentive to save in your country so they take their money elsewhere. This is known as hot money outflows
Could effect LRAS too as rates on business loans may decrease so they will invest more and boost LRAS via quantity quality of capital and improvement in the productive efficiency of an economy
What are the cons of expansionary monetary policy? Evaluation too
Risk of demand pull inflation as a trade off if they cut interest rates for the reasons of growth and unemployment not interest rates. Inflation may overshoot the target
Could also widen CA deficit as households have more income and spend on imports
Keynesian arguments that interest rates lose their effectiveness when they hit their lower bound. The economy then enters a liquidity trap. When IR are already so low then consumers and businesses have already converted their illiquid assets into cash to facilitate spending on GandS or investment or to hoard it because of security reasons. Therefore if central bank tries to cut IR further then individuals already have hoards to spend and invest. They dont need to borrow money. This means you wont see the increase in IR and consumption which this policy might suggest
Negative impact on savers. ROI on savings fall as IR falls. If inflation is higher than the IR in an economy then the real returns on savings could be negative.
Also comes with time lags. Takes about 18 months to 2 years to fully feed through.
Evaluation:
Effectiveness depends on the size of the output gap
Level of consumer and business confidence. If they think they will get promotions then they will have incentive to borrow and spend. For businesses they need to be confident in expectations of demand and profitability then there will be a reason to invest if IR is lower. No guarantee if they’re not confident
Are banks willing to lend/pass on the full cut. The cut will be pointless if they aren’t willing to lend. For example a financial crisis etc. They may hoard cash instead of lending money out
Depends on the size of the rate cut. Bigger cut is more desirable as it make sit much cheaper to borrow and offers more of an incentive to consume and invest
What is contractionary monetary policy? (DECREASE IN AD) and what are the reasons?
To hit the inflation target. Prevent financial sector collapse. Prevent excessive growth of house prices and excessive credit. This is borrowing by households and businesses. If too much of this is happening then there is a risk of the financial sector and a potential recession. Another reason is to reduce excess debt and to promote more savings. High IR will reduce incentive to take out so much debt as more debt interest to be paid back. Can also help reduce CA deficit. As AD falls income falls which means less spending on imports
This is when they use higher interest rates to stop money flowing in the economy and encourage savings
What are the pros of contractionary policy?
Lower demand pull inflation. What if it’s cost push inflation? Then higher IR don’t bring down cost push inflation
Discourage household and corporate debt. If there’s a change in their financial circumstances, there is a big risk of bank failure and risk insolvency. One bank failure can cause lots of other banks to fail too. This is called systemic risk and guarantees a recession in the economy. By reducing borrowing and debt, you are reducing the risk of bank failure.
Promotes More sustainable borrowing - only those who can afford high interest rates will borrow
Encourages saving as there is a higher rate of return. Pensioners and savers to reach financial goals are gaining
More affordable housing as the increased cost of mortgage rates will reduce demand for housing which pulls down the price of houses. This makes it more affordable for first time buyers to access the market
Reduces current account deficit as by reducing incomes, there will be less spending on imports
You’ve also got flexibility for expansionary monetary policy in the future
What are the cons of contractionary monetary policy?
Demand side shocks like lower growth and higher unemployment. Shocks economy into recession. Trade off that central banks look to avoid
Impacts those who owe debt which can decrease living standards and make businesses go bankrupt as paying back loan gets harder
Reduces investment which is bad for short-run and long-run growth. As borrowing is more expensive. Investment also major LRAS determinant so this will worsen that
worsens the current account deficit as it strengthens the exchange rate due to hot money inflows. SPICED. Imports cheaper
