Macro 16 - Monetary policy

Question 1

define monetary policy?

Answer 1

Use of interest rates, money supply and exchange rates to manipulate AD.

Question 2

what target is achieved by using monetary policy?

Answer 2

2% CPI.

Question 3

what is the main method of monetary policy?

Answer 3

changing interest rates.

Question 4

how does monetary policy have an impact on the balance of payments?

Answer 4

If interest rates drop, reward for saving decreases. Hot money flows out which leads to selling pounds and demanding fewer pounds. This leads to depreciation, meaning exports become cheaper and therefore CA deficit narrows.

Question 5

4 evaluation points for monetary policy affecting balance of payments?

Answer 5

1. Time lag, passing on rates.
2. Demand for money could increase, firms may chose to borrow more and therefore leads to appreciation of the pound. Depends on which one is bigger because if depreciation is caused by a large recession, then pound is most likely to depreciate.
3. Uk is an island nation and due to deindustrialisation, demand for imports is likely to be inelastic.
4. Depends on what happens to interest rates in other countries.

Question 6

what is expansionary monetary policy and when might the govt want to use them

Answer 6

Increase AD and economic growth by reducing interest rates or keeping them low. Used during a recession.

Question 7

what is contractionary fiscal policy and when might the govt want to use them?

Answer 7

Reduce AD and economic growth by increasing interest rates or keeping them high. Used in times of high inflation.

Question 8

illustrate the concept of Expansionary and contractionary fiscal policy on a daigram?

Answer 8

expansionary - shift AD to the right.
contractionary - shift AD to the left.

Question 9

what is it called when banks try to increase money supply?

Answer 9

quantitative easing.

Question 10

when might governments want to use quantitative easing?
How do they do it?

Answer 10

when interest rates fall greatly in a recession, and people still dont buy.

1. print more money.
2. buy bonds price of bonds will increase.
   as price of bonds and yield have inverse relationships, low yield allows private investors to lend to private sectors.

Question 11

what is the yield formula?

Answer 11

coupon/market price x 100 = yield

Question 12

define quantitative easing?

Answer 12

When the Bank of England purchases government assets (bonds) in order to lower interest rates and get banks to lend more money.

Question 13

Why might quantitative easing not work as expected?

Answer 13

1. Assumes investment will increase.
2. Relies on animal spirits to be high.

Question 14

who sets the interest rates?

Answer 14

Monetary policy committee (MPC). They operate independently from the government and are tasked to achieve the main target of 2% CPI.
(plus minus 1 is accepted)

Question 15

Why is it considered beneficial to have IR set by an independent body?

Answer 15

so the government doesn’t manipulate interest rates.

Question 16

how many members in the monetary policy committee?

Answer 16

9 members appointed ny the chancellor.

Question 17

what does the governor of the BOE have to do if the committee fails to reach target of 2% CPI?

Answer 17

He has to write a letter to the chancellor explaining why the bank has failed to meet the inflation target.

Question 18

what indicators of inflationary pressure does the MPC look for before setting interest rate in order to make an accurate decision?

Answer 18

• Animal spirits.
• House prices.
• GDP rate of growth in the next 18 months.
• Unemployment rates.
• strength/weakness of the currency.
• Level of spare capacity.
• mortgage lending, getting approved?

Question 19

why does the MPC look to control inflation in 2 years time when setting interest rates?

Answer 19

Transmission mechanism takes roughly 18 months to work through the system.

Question 20

7 limitations of monetary policy:

Answer 20

1. Time lags.
2. Liquidity trap.
3. Difficult to control many objectives.
4. Bubbles.
5. Differences in IR sensitivity.
6. Need to rebalance UK economy.
7. Difficult to tackle cost push inflation.

Question 21

Explain “time lag” as a limitation of monetary policy?

Answer 21

If BOE changes base rate, it can take up to 18 months for the effects to show in the economy.

Question 22

Explain “liquidity trap” as a limitation of monetary policy?

Answer 22

This is when a cut in interest rates fail to stimulate economic activity. This may be because of low confidence or banks don’t want to pass the base rate onto consumers.

Question 23

Explain “difficult to control many objectives” as a limitation of monetary policy?

Answer 23

Increase in interest rates reduce the inflation level but also economic growth due to more savings.

Question 24

Explain “Bubbles” as a limitation of monetary policy?

Answer 24

Monetary policy can cause bubbles. Bubbles are an unsustainable increase in the price of an asset overtime. This usually happens when IR is soo low and people have access to credit (money) which encourages borrowing.
eg: mortgages, increasing demand for housing causing a rise in house prices.

Question 25

Explain “differences in IR sensitivity” as a limitation of monetary policy?

Answer 25

Some regions in the UK are more prone to IR changes than others. London is disproportionately affected by changes in IR because the home ownership in London is higher. Economic activity in london may drop.
This assumes IR leads to greater investment but in reality confidence may be low.

Question 26

Explain “Need to rebalance Uk economy” as a limitation of monetary policy?

Answer 26

The UK government is too reliant of consumption. IF consumption falls. economy goes into a recession. The UK has an objective to rebalance the economy away from consumptions and towards investment and net exports.

Question 27

Explain “Difficult to tackle cost push inflation” as a limitation of monetary policy?

Answer 27

This is because cost push inflation is usually caused by external factors.

Question 28

what happened to inflation in 2009-2011 and why?

Answer 28

Rising inflation due to rising Ad after financial crisis.

Question 29

why is there little link between inflation and IR?

Answer 29

Because the biggest cause of inflation is cost push factors.