Central Banks & Monetary Policy

Question 1

Monetary Policy

Answer 1

Monetary Policy: Used to control money flow of economy, using wide
range of policy tools
- Done by Bank of England, became independent from Gov in 90’s
- Central Bank manipulates:
- Interest rates
- Supply of money/credit
- Exchange rate

Question 2

Monetary Policy Committee (MPC)

Answer 2

Monetary Policy Committee (MPC): Alters interest rates to control supply of money, independent from Gov., consists of 9 members who meet 8x a year to discuss what rate of interest should be
- Interest rates used to help meet Gov. target of price stability & 2% inflation, since it alters the cost of borrowing and reward for saving
- Bank controls base rate (interest rate set by central banks for lending to other banks), used as benchmark for interest rates set by commercial banks

Question 3

Functions of a Central Bank:

Answer 3

• Manages currency, money supply & interest rates in economy
• Central banks issue physical cash (notes & coins) securely & use methods to
  prevent forgery, so people trust money
• Central bank can regulate bank lending to ensure there is stability in financial system

Question 4

Monetary Policy Instruments:
Interest Rates

Answer 4

Interest Rates: Reduction (i.e. expansionary monetary policy) affects each determinant of AD (C+I+G+X-M)

Consumption: Low interest rates reduce opportunity cost of saving, cheaper to borrow from commercial banks
- Households w/ variable rate mortgages, lower repayments, increases disposable income, increases marginal propensity to consume
- Lower base rates increases no. of mortgages, demand for houses rises, supply of houses inelastic, results in increase in house prices
- Triggers a positive wealth effect, where people spend more as they feel
richer, boosts consumption

Investment: Low interest rates, cheaper for firms to borrow, use cheap loans to fund R&D or other investment
- Investment will also increase if consumer spending does, according to accelerator effect, as investment is a derived demand

Government Spending: Low interest rates mean government debt repayments will be lower, will encourage
the government to issue more bonds to contribute to higher levels of government spending.

Exports Minus Imports (X-M): Interest rates affect amount of hot money flowing into economy
- Low interest rate reduces flow of hot money into economy, as rate of return is lower t
- Weakens exchange rate, increases supply of the £ on FOREX markets - or decreases the demand for the £
- Increases price competitiveness of exports, as they become cheaper. However, imports become more expensive, higher costs of production/prices, which would eliminate any increase in exports.