Financial Market and Monetary Policy Flashcards
The central bank takes action to influence the manipulation of
Interest rates
The supply of money/credit
The exchange rate
How does expansionary monetary policy affect Consumption
Low interest rates reduce the opportunity cost of saving (see notes), because it is cheaper for consumers to borrow from commercial banks.
Households with variable rate mortgages benefit through lower repayments, which increases disposable income and, as a result, increases their marginal propensity to consume.
Lower base rates (and therefore interest rates) also increases the number of mortgages taken out by households, so the demand for houses rises. Due to the supply of houses in the UK being PES inelastic (see notes), this results in a proportionately larger increase in house prices
Expansionary monetary policy affecting investment
Low interest rates mean it is cheaper for firms to borrow from commercial banks, and use these cheap loans to fund R&D or other forms of investment.
Expansionary monetary policy affecting government spending
Low interest rates mean government debt repayments will be lower, and so will encourage the government to issue more bonds to contribute to higher levels of government spending.
Expansionary monetary policy affecting (X-M)
Affect the amount of** hot money flowing into an economy: this being money
that flows from different countries in search of the highest interest rates to maximise short-term profits. So a low interest rate would reduce the flow of hot money into the economy, as the rate of return is lower than in other countries. This weakens the exchange rate, as it increases the supply of the £ on FOREX markets - or decreases the** demand for the £ (see notes). This** increases the price competitiveness of exports, as they become
cheaper**. However, imports become more expensive, and this could mean higher costs of production (and therefore prices), which would eliminate any increase in exports
Quantitive Easing
Used by banks to help to stimulate the economy when standard monetary
policy is no longer effective, i.e. interest rates cannot be lowered any further than their current rate.
Bank of England electronically creates more money.
➔ It uses this to buy government and bank bonds.
Effects of QE on banks
Banks now have more money, they will naturally lend more to households and firms, thus increasing overall demand which will restimulate the economy.
However, this assumes banks will simply not sit on the extra cash the BoE offers them, as they may be concerned about their clients’ abilities to repay loans, like we saw during the 2008 Great Financial Crisis
Effects of QE on Government Spending
Now that the central bank has also bought up government bonds (often referred to as gilts), the government has the funds to spend more in the economy, for example on training and education (T&E) or other forms of capital spending, in the hopes of boosting the economy.
Key limitations of QE
As the supply of the £ increases, the UK experiences a depreciation of its currency on FOREX markets. Although this makes exports cheaper, imports become more expensive, and because the UK imports a lot of raw materials from overseas, it could trigger cost-push inflation.
Factors considered by the MPC when setting bank rate
Unemployment rate
Savings rate
Consumer spending
High commodity prices
Exchange rate
Functions of money
A medium of exchange
A measure of value (unit of account)
A store of value
A method of deferred payment
What is the money supply
Stock of currency and liquid assets in an economy. It includes cash and money held in savings accounts.
Role of financial markets in the wider economy
To facilitate saving
To lend to businesses and individuals
To facilitate the exchange of goods and services
Ripple effect caused by rise in interest rates
Less borrowing
Less consumer spending
Less investment by firms
Less confidence among consumers and firms.
More savings
Decrease in exports
Increase in Imports
Transmission Mechanism
Change in interest rate - Affects market rates
Asset prices -
Expectations/Confidence
Exchange rates
All leads to inflation
Takes 18 month to feel full effect of interest rate change
3 Exchange rates systems
Fixed exchange rate - where the governement or its central bank sets the exchange
Floating exchange rate - free to move with changing supply and demand for currency
Hybrid exchange rate - mixture of both
managed floating - left to market forces but the government will occasionally intervene to influence exchange rate.
Semi-fixed - allowed to fluctuate within a set band of exchange rates
Pegged - the value of the currency is “pegged” to another currency
Fixed exchange rate
Uses interest rates and by buying and selling currecny (using foreign currency reserves) to keep at a target rate
Ways of measuring exchange rates
Nominal exchange rate - direct comparisom
Real exchange rate - adjusted to price levels
Bilateral exchange rate - comparison of 2 currencies
Effective exchange rate - a countries currency copared to a basket of currencies.
How do governments and market forces cause currencies to fluctuate
Devaluation of fixed is done by governement selling the currency (opposite is revaluation for fixed rates)
Depreciation is for floating rates - lowering interest can affect it.
Advantages of floating exchange rates
reduced need for currency reserves
Means governement doesnt have to use monetary policy to help maintain exchange rate and it can be used for other objectives
Reduce BOP current account deficit
Disadvantage of floating exchange rates
Fluctuate widely making it difficult for businesses to plan ahead
Speculation can artifically strength ER causing reducing in international competitiveness
Falls in exchange rates cause inflationary pressures if demand for imports tend to be price inelastic
Advantage of fixed rates
Speculation is reduced, unless dealers feel rate is no longer sustainable
Easy to plan ahead encouraging investment (FDI)
Disadvantages of fixed rates
Loses control of monetary policy and they need it to keep exchange rate at dersired level.
Difficult to maintain
Speculators feel fixed exchange rate isnt sustainable they will take advantage and sell the currency
How can countries improve competitiveness
Improve education and training
Create incentives for firms to invest (tax cuts)
Improve infrastructure
Cut red tape (deregulation)
