7. Monetary Policy Flashcards
What is monetary policy
Monetary policy involves changes in interest rates, the supply of
money & credit and exchange rates by the central bank to
influence the macro-economy and achieve target outcomes.
lowering interest rates stimulates borrowing and spending.
Central Bank
A central bank is the monetary authority and major
regulatory bank in a country. A central bank is responsible
for operating monetary policy and maintaining financial
stability.
OBJECTIVES OF MONETARY POLICY – THE USA
Price stability - 2% inflation
Maximum sustainable employment - minimising unemployment
OBJECTIVES OF MONETARY POLICY – THE UK
Price stability - 2% inflation
Support economic growth
Monetary stability
Monetary stability means a lengthy period of stable prices and market confidence in the external value of a currency. Stable prices are defined by the inflation target, which the Bank of England seeks to meet through the decisions taken by the Bank’s Monetary Policy Committee (MPC).
Base interest rate
The main interest rate set by a nation’s central
bank. This is the rate of interest charged to
commercial banks if they must borrow from
the central bank when short of liquidity.
Market interest rates often take their cue
from changes in the Base Interest Rate.
Nominal interest rate
The nominal rate of interest is known as the
money rate of interest. For example, the
nominal interest rate paid to covers, or the
nominal rate of interest charged on a loan.
Real interest rate
Nominal rate of interest adjusted for inflation.
For example, if the nominal interest rate on a
loan is 5% and the inflation rate is 3%, then
the real interest rate on the loan is +2%.
Real interest rates can be negative if the
nominal interest rate is lower than inflation.
Mortgage interest rates
Mortgage interest rates are the rates that
lenders charge on a home loan.
They’re typically expressed as a percentage
of the loan amount and are paid in addition
to the principal, or the amount borrowed.
Mortgage interest rates are influenced by
several factors, including the general level of
interest rates in the economy, the
creditworthiness of the borrower, and the
loan-to-value ratio (LTV) of the mortgage.
Factors considered when setting bank rates:
Rate of growth of real GDP and the estimated size of the output gap
Forecasts for price inflation
Rate of growth of wages and other business costs
Movements in a country’s exchange rate
Rate of growth of asset prices such as house prices
Movements in consumer and business confidence
External factors such as global energy prices and inflation in other countries
Financial market conditions including the rate of growth of credit / money
HOW HIGHER INTEREST RATES CONTROL INFLATION
Raise the cost of borrowing, slows consumption and investments. reduces AD, eases upward pressure on retail prices.
Expansionary monetary policy
Cuts in interest rates or an increased supply of
credit designed to increase AD.
INTEREST RATE TRANSMISSION MECHANISM
- Banks cuts their main interest rate
- sends a signal to financial markets
- possible change in market interest rates
- change in componenets of AD
- change in demand - pull inflationary pressure
- change in rate of inflation
Lower interest rates and the exchange rate
- central banks cuts base rate of interest
- commercial banks cut their interest rates including on saving
- rate of return on saving decreases in UK.
- investors might move some of their savings out of the UK.
- ouflow of ‘hot money’ from the UK.
- assume it flows to switzerland
- investors will be selling GBP and buying swiss franc
- GBP will depreciate against the swiss franc
Negative interest rates
When a nation’s central bank charges commercial
banks interest for holding funds with them. This
policy would be designed to get commercial banks to
lend out to people and businesses rather than hold
money on account at the central bank. In an extreme
form, savers might be charged interest on their
savings.
Deflationary monetary policy
A deflationary monetary policy is an approach
taken by a central bank to reduce the money
supply or raise interest rates with the primary
goal of decreasing aggregate demand and
slowing down economic activity. The aim of a
deflationary monetary policy is to combat
inflation and maintain price stability.
Economic effects of higher interest rates
- consumer spending - reduces the ral value of disposable income
- household saving - increases in MPS and decrease in consumer demand
- investment - borrowing more expensive, reduces investment in new capital
- exchange rate - a rise in i means appreciation of domestic currency
- asset prices - reduce value of assets - lower wealth
Effects of higher interest rates on businesses
increase in cost of borrowing - less investment
decrease in consumer spending - reduces effectiveness of disposable income
more expensive to refinance existing debt
leads to currency appreciation, exporters become less price competitive
Effects of higher interest rates on households
borrowing is more expensive - less consumption - AD decrease
worse consumer confidence , people fear a recession
increased mortgage rates cause a drop in average house prices.
good new for savers.
