chapter 14 monetary policy and the price level Flashcards
ECB - monetary policy to achieve price stability
the primary aim of the ECB’s monetary policy is to maintain price stability. this means that they want to keep inflation rates close or below 2% in the medium term. monetary policy is defined as - those actions by the ECB which influence the money supply, interest rates or the availability of credit.
1.lowering interest rates (the base rate)
2.increasing availability of credit
3.printing more money (buying bonds/ open market operations)
if inflation continues at a high rate in Europe, outline measures the ECB could implement to address high inflation rates
- increase interest rates - if the ECB increases interest rates it would act as an incentive to save. this should have the effect of reducing demand pull inflation in the economy. it would also act as an incentive to borrow as the cost of borrowing has increased. this should also have the effect of reducing demand pull inflation
- reducing access to credit - if the ECB make accessing credit harder it should have the effect of reducing demand pull inflation in the economy.
- money supply - if money supply grows slower than real output, there will be less money chasing more goods and services available and so inflation will fall. a contractionary monetary policy stifles demand and reduces prices
what is quantitative easing ? ECB
the ECB buying financial assets from commercial banks
what is quantitative tightening ?ECB
the ECB selling financial assets on its balance sheets to private investors
what are the benefits to Ireland of price stability being achieved by the ECB
1.maintain the value of money - peoples purchasing power( those at work or those on fixed incomes i.e. pensioners) is maintained and as a result the people have a higher standard of living
- improved international competitiveness - if a country’s rate of inflation is lower than their trading partners then exports would become cheaper and more competitive
- increased consumer demand - consumers may be more inclined to spend resulting in increased employment and economic growth
- wage restraint - trade unions are less likely to look for pay increases to compensate their members for rising prices as prices are stable
- government revenue could increase - with more direct and indirect taxes collected if spending rises
implications for Ireland of being part of the Eurozone
- monetary policy may not be suitable for Ireland - the ECB’s decisions are taken to benefit the Euro area as a whole. Occasionally, these decisions can be contrary to what the Irish economy requires but as we area part of the Eurozone, we are subject to these rules nonetheless.
2.exchange rate risk is eliminated - the implementation of the € allows for no uncertainty when it comes to buying goods and services for other Eurozone countries
3.transaction costs are eliminated - the € ensures that there are no fees for currency exchange. this helps promote tourism within the Euro area as it relatively more convenient
- increased globalisation - the € has improved the globalisation of the Irish economy. by using the same currency as large economies such as France, Germany and Italy, Ireland has become increasingly integrated into the global economy
what are the areas of responsibility of the European central bank (ECB)
- price stability- monitors inflation in member countries and adjusts the base ECB interest rate so as to adjust spending and maintain price stability. Targets 2% inflation in the medium term
- decides Eu monetary policy - ECB implements monetary policy- monitors and advises on rates of interest, money supply, credit availability & protects the value of the euro
- manages official reserves of the euro area countries - it holds and manages the EU’s official holdings of gold, foreign currencies and other reserves held as security against the issue of the euro. the ECB manages these reserves on behalf of the countries
- supervises financial institutions in the eurozone- the member central banks of the eurozone countries must provide prudential supervision of credit institutions and ensure stability in the financial system/lending to eurozone central banks
5.issues euro currency - the ECB has the exclusive/sole right to issue euro bank notes and coins within the euro area. local central banks may print them, but the ECB allows it.
what is price inflation ?
price inflation is defined as a sustained increase in the general level of prices over a timer period
what is demand pull inflation ?
it is a type of inflation that occurs when there is a persistent/ continuous increase in aggregate demand (AD>AS).
the economy cannot produce enough goods& services to meet demand, causing prices to rise.
it usually occurs when an economy is close to or at full employment as increases in demand are more likely to be met by price increases rather than increased output
what is cost push inflation ?
cosh-push inflation is caused by continuous rises in the costs of production caused by firms reacting to increased costs by reducing their output. the selling price of goods are increased to compensate for an increase in the costs of production
what is the difference between CPI vs HICP ?
CPI - the consumer price index (CPI) measures cost of living in Ireland using a weighted basket of goods and comparing changes to a base year - this is the Irish version
HICP - the harmonised index of consumer prices is designed to assess price stability and is not intended to be a cost of living index. it is a standardised method each EU country uses so they can be compared and used to calculate overall price stability in the EU. HICP data is published by Eurostat, while our CPI is published by the CSO .
what steps are taken to calculate the CPI
- choosing a representative base year
- decide what goods will be put into the CPI (based on the household Budget Survey (HBS)
- gather data - get the price of each good for each time period being observed.
- find how much a typical consumer spends on the good as a proportion of total income (attach a “weight” to each good)
- multiply the price change index (the simple price index) for each goof by its weight.
- add up all the price changes to get the overall change in price.
what are the uses of the CPI , other than as a measure of the rate of inflation
- measures international competitiveness/ international comparisons - By comparing our inflation rate with that of our trading partners we can determine whether our competitiveness on international markets is improving or getting worse
2.indicator of economic performance - the CPI, together with statistics on employment, economic growth, exchequer returns etc, provide an indicator of the country’s economic performance and therefore better informs the government on actions they should take
3.indexation of savings/ investments - some savings schemes have “index-linked” returns meaning that the rate of interest will be equal to the rate of inflation. Individuals with insurance/pensions policies may be able to increase their contributions so at to maintain the real value of these policies.
4.used by government indexing tax bands/ social welfare payments - the government may use decreases in the CPI to index tax bands so that taxpayers are paying more tax. similarly the government may use decreases in the CPI to decrease rates of social welfare so as not to interfere with the standard of living of the recipients and thereby reduce government expenditure
- used in pay negotiations - historically trade unions/ employees have used increases in the CPI as the basis for making claims for a wage increase.
what are the effects of price inflation on the Irish economy
- lower standard of living- because of the higher cost of living, people have reduced purchasing power which causes a reduction in their standard of living.
2.increased wage demands - workers, experiencing a reduction in their standard of living, will try to negotiate increases to compensate for the higher cost of living
- loss of competitiveness
4.loss of employment
5.government finances - savings discouraged/consumption encouraged
- borrowing encouraged
8.increased disparity between different sectors of the population
9.pressure on social partnership/industrial relations unrest
10.balance of payments problems - uncertainty - rising inflation rates in Ireland creates uncertainty for investment decisions. makes business planning and profit calculation difficult.
government solutions to help reduce inflation
- increase direct taxation - with less income in their pocket’s consumers may spend less in the economy thus reducing demand pull inflation
- decrease government current expenditure - government expenditure is an injection into the circular flow of income. decreasing government current expenditure decreases aggregate demand and thus demand pull inflation in the economy
3.reuce costs of government provided utilities - if the government reduced charges on government provided utilities it will reduce the cost of production of firms and thus reduce cost push inflation
4.price caps
5. reduce indirect taxation
