Central Banks And Monetary Policy

Question 1

Expansionary monetary policy - policies to increase AD

Answer 1

1. Increase inflation
2. Increase growth
3. Reduce unemployment

Question 2

Contractionary monetary policy - policies to decrease AD

Answer 2

1. Reduce inflation
   2.Prevent asset/ credit bubbles
2. Reduce excess debt and consumer saving
3. Reduce current account deficit

Question 3

Monetary policy

Answer 3

Involves changes in interest rates, the supply of money and credit and exchange rates to influence the economy.

Question 4

The Bank of England

Answer 4

• Controls monetary policy
• Uses policy interest rates (bank/base rate) to help regulate the economy and meet macro objectives.

Question 5

Types of interest rates

Answer 5

• Bank loans (individuals (“C”) / firms (“I”)
• Mortgages
• Credit card rates (“C” / businesses day to day)
• Payday loans
• Corporate bonds - firms borrowing money
• Government bonds (“G”)
• Savings account

Question 6

Bank/ base rate - set by BOE

Answer 6

• 5.25%
• Most important interest rate in the UK.
• It’s set by the monetary policy committee who is part of the BOE.
• It influences many other interest rates in the economy

Question 7

Government policy options to manage AD:

Answer 7

Monetary policy (affect most components of AD: C, I, X-M)

Fiscal policy (aimed at the ‘G’ on AD)

Supply side policies

Question 8

Monetary policy is used to manage AD in the economy:

Answer 8

AD = C + I + G (X - M)

Monetary policy can be used to increase AD in the economy (expansionary monetary policy) or to reduce AD in the economy (contractionary monetary policy)

Question 9

Transmission mechanism of interest rate policy

Answer 9

Question 10

Quantative easing

Answer 10

• QE involves the introduction of new into money into the national supply by a central bank
• In the UK the BOE creates new money electronically to buy assets (mainly bonds) from financial institutions such as the commercial banks / insurance companies

Question 11

How does quantitative easing work in the UK?

Answer 11

1. The central bank (BoE) creates new money electronically to make large purchases of assets (bonds) from the private sector
2. Increased demand for government bonds causes an increase in the market price of bonds and therefore causes their price to rise.
3. A higher bond price causes a fall in the yield on a bond (there is an inverse relationship between bond prices and yields)
4. Those who have sold their bonds may use the extra funds to buy assets with relatively higher yields such as shares of listed businesses and corporate bonds
5. Commercial banks receive cash from asset purchases and this increases their liquidity. This may encourage them to lend out to customers which will help to stimulate an increased in loan financed capital investment in the economy.

Question 12

Raising interest rates

Answer 12

= Cost of borrowing increase
= Lower consumer confidence
= Higher unemployment + lower wages
= Stock prices to fall

Question 13

Interest rate

Answer 13

The cost of borrowing money

Question 14

Why do central banks raise interest rates?

Answer 14

To control inflation

Question 15

If inflation is high, interest rates will…

Answer 15

Increase

Question 16

Contractionary monetary policy

Answer 16

Used by the BOE to lower inflation, restrict growth and close the positive output gap

Question 17

Expansionary monetary policy

Answer 17

Is used by the BOE to stimulate economic growth and increase aggregate demand (causes demand pull inflation)

Involves cutting interest rates or increase the money supply to boost economic activity.

Question 18

A ________ output gap occurs when there is inflation

Answer 18

Positive

Question 19

Expansionary monetary policy diagram

Answer 19

Question 20

How does expansionary monetary policy work

Answer 20

Question 21

Why expansionary monetary policy may not work:

Answer 21

• If confidence is very low, then people may not want to invest or spend, despite lower interest rates.
• In a credit crunch, banks may not have funds to lend, therefore although the Central Bank cuts base rates, it is still difficult to get a loan from a bank.
• Commercial banks may not pass the base rate cut on.
• It depends on other components of aggregate demand. Expansionary monetary policy may boost consumer spending, however, if we are in a global recession, then there may be a strong fall in exports which outweighs the improvement in consumer spending.
• Time Lags. It can take up to 18 months for interest rate cuts to increase spending. For example, people may have a two-year fixed rate mortgage. Therefore, they only see the impact of the rate cut when they remortgage.

Question 22

Contractionary monetary policy

Answer 22

Question 23

Contractionary monetary policy

Answer 23

Involves increasing interest rates to lower inflation, however leads to lower economic growth

Question 24

Contractionary monetary policy diagram

Answer 24

Question 25

Higher interest rates tend to reduce AD because:

Question 26

Effectiveness of tight monetary policy

Answer 26