Financial Markets and Monetary Policy

Question 1

What is monetary policy?

Answer 1

The manipulation of the rate of interest, the money supply and exchange rates to influence the level of economic activity.

Question 2

How does monetary policy work?

Answer 2

The bank (MPC) meet every month to decide the level of interest and other changes to policy.
- they consider a wide range of macroeconomic variables (including GDP, unemployment, exchange rate, house prices, investment by firms and GDP growth in other nations)

Use interest rates to influence the money supply and quantitive easing. If inflation remains at target, it will give confidence to…
- consumers - spending
-firms - invest
-workers - wage demands

Question 3

What are monetary policy goals?

Answer 3

• maintain a low inflation rate, 2% CPI +/-1%
• monetary policy is delegated to the BOE who set interest rates and controlling the money supply.
• recently the bank assist in stimulating economic growth and employment.

Question 4

How is the Monetary Policy organised?

Answer 4

The MPC set interest rates. There are 9 members (5 from bank, 4 independent).
- chaired by the governor of the BOE Andrew Bailey (meet once a month)
- independent from government which gives it more credibility (no political influence)

Question 5

What are interest rates?

Answer 5

Described as the price of money, costs of borrowing and the reward for saving.

Question 6

what is the link between the interest & exchange rate?

Answer 6

1 - global investors will deposit their money in a country where they get the best return (highest interest rates).
2 - E.G Hypothetically, the US & USA have the same interest rates, the return is the same.
3 - if the UK raise interest rates, investors will move their money to the UK for the best return.
4 - they will have to sell their dollars and buy pounds to deposit in the UK, increasing demand and echange rate for UK pounds.
5 - this feeds through to exports, making them less price competitive and imports attractive
6 - this hot money process (international funds moving around for the best interest rates) worsens the BOP on the current account.

Question 7

How is the money supply a tool for monetary policy?

Answer 7

• if the BoE expand the supply of notes and coins it will encourage spending.
• this must be careully managed as an increase in the circulation and supply of money reduces its value and creates inflationary pressure.

Question 8

How are the rules on bank lending and credit agreements a tool for monetary policy?

Answer 8

• if the BoE tighten rules on how much credit and loan funds banks can make available, this will constrain investment and consumption.
• looser credit regulations improve the avaliablity of credit and loans and general spending will rise.

Question 9

How is quantititve easisng a tool for monetary policy?

Answer 9

• the UK 2008 recession meant the BoE were expected to cut interest rates to stimulate economic activity.
• interest rates were at 0.5% and had little downwards movement to manipulate the economy with.
• banks were nervous to lend money so the BoE were to boost funds available for lending to frims.
• 375bn was raised in QE

(effective? perhaps the recession would have been eorse if the BoE hadn’t intervened this way).

Question 10

how is monetary policy and AD linked?

Answer 10

1- consumption = low interest rates incentives borrowing and spending (especially general spending and consumer durables)

2 - investment = low interest rates make investment projects less costly and more profitable/attractive so investment rises.

3 - net exports = low interest rates mean a weaker pound (less attractive to currency investors)

Question 11

how is the wealth effect an impact of monetary policy?

Answer 11

• interest rates fall, leading to a greater demand for housing through more affordable mortgages and increases in property prices.
• homeowners can borrow against the value of their home and increase consumption.
• it is likely that risisng house prices will improve consumer confidence and encourage further consumption.

Question 12

how is the savings ratio an impact of monetary policy?

Answer 12

• high interest rates lead to a higher saving ratio as there is a larger proportion of income likely to be saved and less spent on consumption.
• low interest rates = less incentive to save and a reward to spend on consumption instead of save.

Question 13

what is the wealth effect?

Answer 13

A behavioral economic theory suggesting people spend more as the value of their assets rise.

Question 14

what is the savings ratio?

Answer 14

The ratio of savings by individuals or households to disposable income, expressed as a percentage.

Question 15

How would you analyse expansionary monetary policy?

Answer 15

1) assume the BoE is concerned that slow economic growth will feed through to lower inflation, they may cut interest rates.

2) this reduces the savings ratio and makes borrowing more attractive so consumption rises.

3) this increases RNO from Y to Y1

4) there will be the added benefit of creating employment

Question 16

How would you analyse contractionary monetary policy?

Answer 16

1) assume the BoE is concerned that inflation is above the 2% target, they may increase interest rates to reduce inflationary pressure.

2) this makes aving attractive and reduces consumption in addtion to investment from firms.

3) this will reduce inflationary pressure as the price level falls from P to P1

4) the trade off is a reduction in RNO to Y1, damaging economic growth and employment.

Question 17

How would you analyse the supply side effects monetary policy?

Answer 17

1) Monetary policy has effects on AD and also influences LRAS,

2) A cut in interest rates might stimulate business investment into the capital process to improve their productivity and efficiency which shifts LRAS to LRAS1

3) investment is a component of AD, AD will shift to AD1

4) Productive capacity has increased to FE1 and increases in AD feeds through to higher growth and employment. in this example, there has been no change in price level.

Question 18

Is monetary policy effective?

Answer 18

• the size of the change in interest rates will vary the impact
• timing of rate changes & how long it takes to work
• size of the multiplier
• the stage of the economic cycle the economy is currently operating at
• primary target is to control inflation but may conflict with other objectives
• BoE may be hampered by innacurate data
• interest rates slove demand-pill but may be less effective with cost push cases.

Question 19

what is demand pull inflation?

Answer 19

when the total demand for goods and services (AD) increases to exceed the supply of goods and services (AS) that can be sustainably produced.

Question 20

what is cost push inflation?

Answer 20

when the total supply of goods and services in the economy that can be produced (AS) falls, often due to an increase in the costs of production.