Central banks and monetary policy

Question 1

What is the definition of monetary policy

Answer 1

Changes to the interest rate, money supply and the exchange rate by the central bank in order to influence AD

Question 2

What are the main functions of a central bank?

Answer 2

-Issuing currency (e.g., Bank of England issues the pound sterling).
-Acting as a lender of last resort for banks facing liquidity crises.
-Implementing monetary policy to control inflation and economic stability.
-Managing exchange rates to stabilize the currency.
-Regulating banks to ensure financial stability.

Question 3

What does monetary policy involve?

Answer 3

-Interest rates (e.g., the Bank Rate)
-The supply of money and credit in the economy
-Exchange rates to impact trade and inflation

Question 4

What is expansionary monetary policy and how does it work?

Answer 4

Policies to increase AD, Increase inflation, increase growth and reduce unemployment

Question 5

What is contractionary monetary policy and how does it work?

Answer 5

Policies to reduce AD, Reduce inflation, prevent asset/credit bubbles, reduce excess debt, promote saving and reduce the current account deficit

Question 6

What are the three current objectives of UK monetary policy as set by the government?

Answer 6

-Achieve price stability by targeting 2% CPI inflation (±1%).
-Support economic growth and high employment.
-Maintain financial stability.

Question 7

What is the role of the Monetary Policy Committee (MPC)?

Answer 7

-Reviewing economic data and forecasts monthly
-Setting the Bank Rate to meet inflation and economic growth targets
-Maintaining inflation at the government’s target of 2%

Question 8

How does a depreciation in the exchange rate affect aggregate demand (AD)?

Answer 8

A weaker currency:

-Boosts exports (cheaper abroad) → Increases AD
-Raises import prices → Imported inflation

Question 9

How does an appreciation in the exchange rate affect aggregate demand (AD)?

Answer 9

A stronger currency:

Reduces exports (more expensive abroad) → Decreases AD
Lowers import prices → Deflationary pressure

Question 10

How do changes in the exchange rate impact macroeconomic objectives?

Answer 10

A weaker currency can increase inflation and stimulate economic growth
A stronger currency can control inflation but reduce growth and employment

Question 11

What are the steps in the monetary policy transmission mechanism?

Answer 11

1)Bank Rate changes: Adjustments made by the MPC
2)Market rates: Impacts borrowing/lending rates for households and firms.
-Domestic demand-
-Higher rates → Reduced consumption and borrowing.
-Lower rates → Increased spending and investment.

                -Exchange rate effect- -Higher rates → Stronger pound → Reduced AD. -Lower rates → Weaker pound → Increased AD.

Inflation and output: Final impacts on price stability and economic growth.

Question 12

How can the Bank of England influence the growth of the money supply?

Answer 12

-Quantitative Easing (QE): Buying financial assets to inject liquidity
-Open Market Operations: Buying/selling government securities to control money flow
-Setting Reserve Requirements (Adjusting how much banks must hold in reserves)
-Changing the Bank Rate (To influence borrowing, lending, and money circulation)

Question 13

Explain the process of expansionary Monetary policy

Answer 13

Increasing AD by decreasing central rates
-Lower credit card interest rates (C increase)
-Lower saving rates (C increase)
-Mortgages rates lower interest (C increase)
-Lower business loan interest rates (I increase )
-Weaker exchange rate (X-M increase)

Question 14

Why does decreasing interest rate weaken the exchange rate?

Answer 14

-Reduced Attractiveness for Foreign Investors
-Increased Supply of the Pound in Currency Markets (As foreign investors sell pounds to convert their funds into other currencies)
-Expectations of Economic Impact (A lower interest rate policy can signal potential economic weakness or a focus on boosting growth through cheaper borrowing)

Question 15

Benefits of expansionary monetary policy?

Answer 15

-Demand-Pull Inflation vs. Budget Deficit, Boosts AD but risks inflation and worsens the government’s budget deficit if fiscal
support is needed

-Liquidity Trap, If rates are already low, further cuts may fail to stimulate demand due to low confidence

-Negative Impact on Savers, Lower interest rates reduce returns on savings, harming savers’ incomes

-Time Lags, Effects take 12–24 months, risking delayed or mistimed outcomes

Question 16

Explain the process of contractionary Monetary policy?

Answer 16

Decreasing AD by increasing central rate
-Less borrowing due to higher cost from higher interest rates
-Encourage saving

Question 17

Pros of contractionary Monetary policy?

Answer 17

-Disinflation (demand pull)
-Discourage household/Corporate debt
-Encourage saving
-More affordable housing
-Reduce CA deficit

Question 18

Cons of contractionary Monetary policy?

Answer 18

-Lower growth
-Higher unemployment
-Impact of indebted
-Reduces investment
-Worsening CA deficit via exchange rate strengthening

Question 19

What is Quantitative Easing (QE)?

Answer 19

-QE is an unconventional monetary policy where a central bank increases the money supply to stimulate the economy

-It involves the central bank purchasing financial assets (like government bonds) from banks and other institutions to inject liquidity into the economy

Question 20

How is Quantitative Easing achieved?

Answer 20

-Asset Purchases, The central bank buys government bonds or other securities

-Increased Bank Reserves, Banks sell these assets and receive newly created money, increasing their reserves

-Encourages Lending, More reserves make banks more willing to lend to businesses and consumers

-Boosts Aggregate Demand (AD), Increased lending leads to higher consumption and investment, stimulating economic growth

Question 21

Key Goal of QE?

Answer 21

To lower long-term interest rates, encourage borrowing/spending, and combat deflation or economic stagnation