Macro 16 - Monetary policy Flashcards
define monetary policy?
Use of interest rates, money supply and exchange rates to manipulate AD.
what target is achieved by using monetary policy?
2% CPI.
what is the main method of monetary policy?
changing interest rates.
how does monetary policy have an impact on the balance of payments?
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.
4 evaluation points for monetary policy affecting balance of payments?
- Time lag, passing on rates.
- 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.
- Uk is an island nation and due to deindustrialisation, demand for imports is likely to be inelastic.
- Depends on what happens to interest rates in other countries.
what is expansionary monetary policy and when might the govt want to use them
Increase AD and economic growth by reducing interest rates or keeping them low. Used during a recession.
what is contractionary fiscal policy and when might the govt want to use them?
Reduce AD and economic growth by increasing interest rates or keeping them high. Used in times of high inflation.
illustrate the concept of Expansionary and contractionary fiscal policy on a daigram?
expansionary - shift AD to the right.
contractionary - shift AD to the left.
what is it called when banks try to increase money supply?
quantitative easing.
when might governments want to use quantitative easing?
How do they do it?
when interest rates fall greatly in a recession, and people still dont buy.
- print more money.
- 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.
what is the yield formula?
coupon/market price x 100 = yield
define quantitative easing?
When the Bank of England purchases government assets (bonds) in order to lower interest rates and get banks to lend more money.
Why might quantitative easing not work as expected?
- Assumes investment will increase.
- Relies on animal spirits to be high.
who sets the interest rates?
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)
Why is it considered beneficial to have IR set by an independent body?
so the government doesn’t manipulate interest rates.
how many members in the monetary policy committee?
9 members appointed ny the chancellor.
what does the governor of the BOE have to do if the committee fails to reach target of 2% CPI?
He has to write a letter to the chancellor explaining why the bank has failed to meet the inflation target.
what indicators of inflationary pressure does the MPC look for before setting interest rate in order to make an accurate decision?
- 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?
why does the MPC look to control inflation in 2 years time when setting interest rates?
Transmission mechanism takes roughly 18 months to work through the system.
7 limitations of monetary policy:
- Time lags.
- Liquidity trap.
- Difficult to control many objectives.
- Bubbles.
- Differences in IR sensitivity.
- Need to rebalance UK economy.
- Difficult to tackle cost push inflation.
Explain “time lag” as a limitation of monetary policy?
If BOE changes base rate, it can take up to 18 months for the effects to show in the economy.
Explain “liquidity trap” as a limitation of monetary policy?
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.
Explain “difficult to control many objectives” as a limitation of monetary policy?
Increase in interest rates reduce the inflation level but also economic growth due to more savings.
Explain “Bubbles” as a limitation of monetary policy?
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.
