Central Banks And Monetary Policy Flashcards
Expansionary monetary policy - policies to increase AD
- Increase inflation
- Increase growth
- Reduce unemployment
Contractionary monetary policy - policies to decrease AD
- Reduce inflation
2.Prevent asset/ credit bubbles - Reduce excess debt and consumer saving
- Reduce current account deficit
Monetary policy
Involves changes in interest rates, the supply of money and credit and exchange rates to influence the economy.
The Bank of England
- Controls monetary policy
- Uses policy interest rates (bank/base rate) to help regulate the economy and meet macro objectives.
Types of interest rates
- 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
Bank/ base rate - set by BOE
- 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
Government policy options to manage AD:
Monetary policy (affect most components of AD: C, I, X-M)
Fiscal policy (aimed at the ‘G’ on AD)
Supply side policies
Monetary policy is used to manage AD in the economy:
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)
Transmission mechanism of interest rate policy
Quantative easing
- 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
How does quantitative easing work in the UK?
- The central bank (BoE) creates new money electronically to make large purchases of assets (bonds) from the private sector
- Increased demand for government bonds causes an increase in the market price of bonds and therefore causes their price to rise.
- A higher bond price causes a fall in the yield on a bond (there is an inverse relationship between bond prices and yields)
- 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
- 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.
Raising interest rates
= Cost of borrowing increase
= Lower consumer confidence
= Higher unemployment + lower wages
= Stock prices to fall
Interest rate
The cost of borrowing money
Why do central banks raise interest rates?
To control inflation
If inflation is high, interest rates will…
Increase
Contractionary monetary policy
Used by the BOE to lower inflation, restrict growth and close the positive output gap
Expansionary monetary policy
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.
A ________ output gap occurs when there is inflation
Positive
Expansionary monetary policy diagram
How does expansionary monetary policy work
Why expansionary monetary policy may not work:
- 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.
Contractionary monetary policy
Contractionary monetary policy
Involves increasing interest rates to lower inflation, however leads to lower economic growth
Contractionary monetary policy diagram
Higher interest rates tend to reduce AD because:
Effectiveness of tight monetary policy
