Demand-side policies – monetary policy Flashcards
What is demand side monetary policy?
use of interest rates, changes in the money
supply and/or changes in the exchange rate to affect AD – run by the
independent Bank of England (BoE) in the UK.
What is bank base rate?
the main interest set by the Bank of England; it is the rate at which commercial banks can borrow from the BoE
What is market interest rates?
rates of interest available to borrowers and savers which vary depending on risk, amount borrowed/saved, access to savings etc; they
typically follow the Bank base rate up/down
What is quantitative easing or QE?
the BoE’s asset purchase scheme to increase the
money supply (It is called quantitative tightening or QT when it is reversed)
What is the inflation target?
in the UK CPI inflation target = 2% +/- 1 % point
Monetary policy adjusted AD to control inflation, meet the target and achieve
price stability
What is the nominal v real rate of interest?
nominal is the actual rate paid; real rate is the
nominal rate adjusted for inflation. E.g. nominal = 5%, inflation rate = 3%, real rate is approximately 2%
Explain how interest rate changes feed through to AD and influence inflation
- Higher interest rates raise the cost of borrowing, which slows consumer spending
C and business investment I. - This reduces AD aggregate demand for goods and services, which in turn eases
upward pressure on retail prices. - Higher interest rates lead to an appreciation of the currency making imports
cheaper which then helps to reduce inflation. - Higher interest rates increase the return on savings, which encourages saving and
helps to reduce inflationary pressures from excess aggregate demand. - Central banks might also think that an increase in the cost of borrowing sends a
message to businesses and unions when negotiating pay settlements.
How can cutting interest rates influence the economy?
- If deflation is a threat, the BoE
can cut interest rates to boost AD
from AD1 to AD2, increasing the
price level from PL1 to PL2 and
increasing real GDP (Y1 to Y2) - If inflation is above target, the
BoE can increase interest rates to
reduce AD from AD2 to AD1,
reducing the price level from PL2
to PL1, but this could slow growth
as real GDP falls (Y2 to Y1) and
cause some unemployment
What is the central bank?
the monetary authority and major regulatory bank in a country. A central bank is responsible for operating monetary policy and
maintaining financial stability e.g. the UK’s BoE.
The MPC consists of nine members who meet eight times a year to set the base rate and decide if QE (or QT) is needed. The Governor of the Bank has the casting vote
What are factors considered by the BoE MPC when making bank base rate decisions?
- Rate of growth of real GDP and the estimated size of the output gap
- Forecasts for price inflation
- Rate of growth of wages and other business costs
- Movements in a country’s exchange rate
- Rate of growth of asset prices such as house prices
- Movements in consumer and business confidence
- External factors such as global energy prices and inflation in other
countries - Financial market conditions including the rate of growth of credit / money
Describe what QE is.
- increases the supply of money in the banking system
- encourage commercial banks to lend at cheaper interest rates to small &
medium sized businesses - is a form of expansionary monetary policy
- has been used as a technique to stimulate aggregate demand at a time
when nominal interest rates have fallen to historically low levels
Explain how QE works.
Central bank creates new money electronically to make large purchases of
assets (bonds) from the private sector
* Commercial banks receive cash from BoE asset purchases, and this
increases their liquidity and might encourage them to lend out to
customers which will help to stimulate an increase loan-financed
consumption C & investment I
* Increased demand for government bonds increases the market price of
bonds.
* Higher bond price causes a fall in the yield on a bond (there is an inverse
relationship between bond prices and yields).
* Lower bond yields/long term interest rates may cause the currency to
depreciate, which can increase net exports (X-M)
* Those who have sold bonds may use the extra cash to buy assets with
relatively higher yields such as shares of listed businesses and corporate
bonds; if asset prices rise this can create a positive wealth effect on C
When has QE been used?
Many countries have used QE e.g UK, USA, Japan, Eurozone…particularly after the Global
Financial Crisis 2007-9 and during the pandemic.
The UK did £375bn of QE 2009-12, £60bn after Brexit vote in 2016, BoE further increased QE
in COVID up to a total of £895bn by March 2021
How does the government use QE to influence AD and the economy?
- The GFC caused a prolonged
recession and interest rates were
brought down to a very low level but
there was still a fear of deflation - The BoE began to QE to boost AD
from AD1 to AD2 because interest
rates could not really be cut more,
helping to increase the price level
from PL1 to PL2 and promoting
economic recovery in real GDP (Y1 to
Y2)
What is expansionary monetary policy?
cut interest rates, increase the money
supply via QE to stimulate AD growth to prevent deflation; a depreciation /
devaluation on the currency can boost AD too
