Central Banks and Monetary Policy

Question 1

Summary

Answer 1

1. Functions of a Central Bank
2. Implementation of Monetary Policy
3. Monetary Policy Instruments
4. Factors Considered by the MPC when setting Bank Rate
5. How Changes in the Exchange Rate Affect Macroeconomic Policy Objectives
6. How Changes in Interest Rates Affect Exchange Rates
7. Quantitative Easing

Question 2

2. Implementation of Monetary Policy

Answer 2

• The central bank takes action to influence interest rates, the supply of money and the exchange rate.

Question 3

3. Monetary Policy Instruments

Answer 3

1. Interest rates
   - The MPC meet each month to discuss what the rate of interest should be.
   - Interest rates are used to help meet the government target of price stability, since it alters the cost of borrowing and reward for saving.
   - Objective of Monetary Policy: Price Stability (2% inflation)
   - The MPC control the ‘Bank Rate’, which ultimately controls interest rates across the economy.

• When interest rates are high: the reward for saving is high and the cost of borrowing is higher.
- Encourages consumers to save more and spend less
• When interest rates are low: the reward for saving is low and the cost of borrowing is low.
- This means consumers and firms can access credit cheaply, which encourages consumption and investment in the economy.
- During the financial crisis: the UK interest rate fell to a historic low of 0.5%
- Despite high inflation, the interest rate was set at a low rate to stimulate AD and boost economic growth.

2. Asset purchases to increase the money supply: Quantitative Easing (QE)
   - This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective.
   - This has inflationary effects since it increases the money supply and it can reduce the value of the currency.
   - QE is usually used where inflation is low / it is not possible to lower interest rates
   - QE is a method to pump money directly into the economy.
   - The theory is that this encourages more investment, more spending, and hopefully higher growth. A possible effect of this is that there could be higher inflation.
3. Forward guidance
   - This is used by central banks to detail what the future monetary policy will be.
   - This is with the intention of reducing uncertainty in markets.

Question 4

4. Factors Considered by the MPC when Setting Bank Rate

Answer 4

• Unemployment: if unemployment is high, consumer spending is likely to fall.
- This suggests the MPC will drop interest rates to encourage more spending.

• Savings: if there is a lot of saving, consumers are not spending as much.
- Interest rates might fall.

• Consumption / Investment: if there is a high level of spending in the economy, there could be inflationary pressures on the price level.
- This would cause the MPC to increase interest rates.

• Exchange rate: A weak pound would cause the average price level to increase. This makes UK exports relatively cheap, so UK exports increase.
- Since imports become relatively more expensive, there would be an increase in net exports. The MPC might consider increasing the interest rate.

Question 5

5. How Changes in the Exchange Rate Affect Macroeconomic Policy Objectives

Answer 5

• A reduction in the exchange rate causes exports to become cheaper, which increases exports. (imports are more expensive so therefore decrease)

• This assumes that demand for exports / imports is price elastic.
• This improves current account deficit

• However, this is inflationary due to the increase in the price of imported raw materials. (Production costs for firms increase = cost-push inflation)

Question 6

5. How Changes in the Exchange Rate Affect Macroeconomic Policy Objectives

Answer 6

• A reduction in the exchange rate causes exports to become cheaper, which increases exports. (imports are more expensive so therefore decrease)

• This assumes that demand for exports / imports is price elastic.
• This improves current account deficit

• However, this is inflationary due to the increase in the price of imported raw materials. (Production costs for firms increase = cost-push inflation)

Question 7

6. How Changes in Interest Rates Affect Exchange Rates

Answer 7

• An increase in domestic interest rates, makes domestic currency more attractive to foreign investors because the rate of return on investment is higher.
- This increases demand for the currency, causing an appreciation.

Question 8

7. Quantitative Easing

Answer 8

• QE: Central bank creates new money electronically which it uses to buy financial assets (e.g. Government Bonds)
• This has numerous effects

1. Purchase of Financial Assets:
   - Increases their price (demand for assets increases)
   - Total wealth increases (higher asset prices make
   people wealthier)
   - Cost of borrowing reduces (higher asset prices = lower yields)
   - These improvements lead to an increase in AD
2. Increase in Money Supply
   - Private sector receive cash they can spend on goods / services or other financial assets.
   - Banks end up more reserves (can increase their lending to households and firms)