9.1 Monetary policy

Question 1

What is monetary policy?

Answer 1

The manipulation of interest rates, exchange rates and money supply to influence the level of economic activity

Question 2

What are the goals of monetary policy?

Answer 2

Inflation 2% +/-1%

Stimulating economic growth

Question 3

What is the MPC?

Answer 3

Monetary policy committee

Question 4

How often do the MPC meet and why?

Answer 4

The MPC meet every month to decide the level of interest rates and any other changes to strategy

Question 5

In order to make their decision what variables do the MPC take into consideration when deciding on monetary policy?

Answer 5

GDP, unemployment, exchange rates, house prices, the level of investment by firms and GDP growth in other countries

Question 6

What is the main tool the MPC has to influence economic activity?

Answer 6

Main tool is interest rates

Question 7

How many members make up the MPC?

Answer 7

9 members: 4 indpendent and 5 from the bank

Question 8

T/F the MPC is independent from the govenment.

Answer 8

True - meaning it has more credibilty as it should be free from political influence

Question 9

How do interest rates and exchange rates link?

Answer 9

Global investors who have significant sums of money to deposit in banks will seek to place it in the country where they get the best return i.e. where the interest rate is highest

If we assume that the UK has the same interest rates as the USA, then for that investor, the return is the same whether they deposit it in the UK or USA

If the UK raises interest rates, then investors will move their money to the UK in order to get the best return

This means they will have to sell their dollars, and buy pounds to deposit in the UK

This increased demand for UK pounds increases the exchange rate

This then feeds through to exports, making them relatively less price competitive, and making imports more attractive

This will have the effect of worsening the balance of payments on current account

Question 10

Other than interest rates, what other tools do the MPC have at their disposal?

Answer 10

The money supply
Rules on bank lending and credit agreements
Quantitive easing

Question 11

What is the money supply?

Answer 11

If the BoE expand the supply of notes and coins in the economy, it should have the effect of encouraging spending

However, this must be carefully managed

If the supply and circulation of notes and coins increases this reduces their value, and hence creates inflationary pressure

Question 12

What is the effect of the MPC putting rules on bank lending and credit agreements?

Answer 12

These rules are quite complex, however if the BoE tighten the rules on how much credit and loan funds banks can make available, this will have the effect of constraining investment and consumption

Equally, looser credit regulations will improve the availability of credit and it is likely that loans and general spending will rise

Question 13

What is quantitive easing?

Answer 13

Bank buys government bonds and over time they rise in price meaning the bank has more money so they can decrease interest rates and people will spend more as there is less point saving

Question 14

In terms of consumption, what to low interest rates mean?

Answer 14

Less incentive to save, more incentive to borrow and therefore higher consumption

Question 15

In terms of consumption, what do high interests mean?

Answer 15

More incentive to save, less incentive to borrow and therefore lower consumption

Question 16

In terms of investment, what does low interest rates mean?

Answer 16

Investment projects become less costly/more profitable thus more attractive, so investment should rise

Question 17

In terms of investment, what to high interest rates mean?

Answer 17

Investment projects become more costly/less profitable thus less attractive, so investment should decrease

Question 18

In terms of NET exports, what does low interest rates mean?

Answer 18

Weaker £ as less attractive to currency investors

Question 19

In terms of NET exports, what does high interest rates mean?

Answer 19

Stronger £ as more attractive to currency investors

Question 20

What is the wealth effect?

Answer 20

Falling interest rates → greater demand for housing through more affordable mortgages and increases in property prices

Homeowners can then borrow against the value of their home and increase consumption

It is also likely that rising house prices will improve consumer confidence and encourage further consumption

Question 21

What is the savings ratio?

Answer 21

The amount of income you save. i.e you earn £2000 and save £200 then your savings ratio is 10%

High interest rates = Higher savings ratio as a higher proportion of income likely to be saved and therefore less spent on consumption

Low interest rates = Lower savings ratio as there is less incentive to save and more incentive to spend on consumption given that the reward for saving is small

Question 22

What does a cut to interest rates do to AD?

Answer 22

Shifts AD right or increases AD

Question 23

What does an increase to interest rates do to AD?

Answer 23

Shift AD left or decrease AD

Question 24

What could a cut to interest rates do to LRAS?

Answer 24

A cut in interest rates might stimulate businesses investment into capital process to improve their productivity and efficiency, causing an increase in LRAS

Question 25

What is hypothecated tax?

Answer 25

A tax used for a specific purpose (i.e sugar tax)

Question 26

What is forward guidance?

Answer 26

BoE tell people what’s going to happen over a period of time

Question 27

What are the advantages and disadvantages of forward guidance?
Advantages (4)
Disadvantages (2)

Answer 27

Advantages:

• Reduces uncertainty
• Reduces Speculation
• Improves business and consumer confidence
• People can act in best interests

Disadvantages:

• Could be incorrect
• Economic shocks can cause changes to this