Macro 9 - Monetary policy

Question 1

Define the term ‘demand side policy’

Answer 1

Demand side policies are a deliberate manipulation by the government of aggregate demand in order to achieve macroeconomic objectives

Question 2

What are the two demand side policies?

Answer 2

• Monetary policy
• Fiscal policy

Question 3

What is monetary policy?

Answer 3

Monetary policy is decision making to influence aggregate demand and the macroeconomic objectives using monetary instruments such as the interest rate, money supply and quantitative easing

Question 4

What is fiscal policy?

Answer 4

Fiscal policy is the government’s management of its spending and taxation with the aim of changing the total level of spending in the economy to influence aggregate demand and the macroeconomic objectives

Question 5

What are interest rates?

Answer 5

Interest rates are the reward for saving money or the price of borrowing money

Question 6

What three different things does monetary policy involve?

Answer 6

• Interest rates
• Money supply
• Exchange rates

Question 7

What are the two types of monetary policy?

Answer 7

• Expansionary monetary policy
• Contractionary monetary policy

Question 8

What is expansionary monetary policy?

Answer 8

Expansionary monetary policy involves increasing aggregate demand using low interest rates, fewer restrictions on the money supply and a weak exchange rate

Question 9

What is the transmission mechanism of monetary policy?

Answer 9

The several different ways in which changes in interest rates influence aggregate demand, output and prices are known as the transmission mechanism of monetary policy

Question 10

What effect will lower interest rates have on consumer spending?

Answer 10

Consumer spending will increase because there is less incentive to save and it is now more affordable to borrow money to buy products on credit

Question 11

What effect will lower interest rates have on those on variable rate mortgages?

Answer 11

For those on variable rate mortgages (mortgages which rates change as interest rates change) a lower interest rate will mean lower mortgage repayments. This leaves more discretionary income to spend on other things increasing consumer spending

Question 12

What effect will lower interest rates have on buying houses?

Answer 12

Lower interest rates makes buying a house more affordable due to cheaper mortgages. This increases the demand for houses and increases house prices. This can lead to a positive wealth effect and a rise in consumer confidence

Question 13

What effect will lower interest rates have on people who rely on interest for their primary source of income?

Answer 13

People who rely on interest for their primary source of income will see falling disposable income and may spend less

Question 14

What effect will lower interest rates have on investment?

Answer 14

Investment will increase because it is cheaper to borrow money and take out loans. This reduces costs of investing and increases possible profits making it more attractive

Question 15

Why may investment not increase when there are lower interest rates?

Answer 15

• If businesses are not confident they will not risk taking out loans
• If they feel the rate decrease will not last for long they will also not take out loans and invest
• If businesses have lots of spare capacity there will be little need to invest to meet consumer demand as they can use existing resources

Question 16

What effect will lower interest rates have on net exports?

Answer 16

• The exchange rate of the pound falls
• UK exports increase as UK goods become cheaper and imports decrease as foreign goods become more expensive
• The balance of payments improves and net exports increases

Question 17

Draw a diagram to show the impact of expansionary monetary policy

Answer 17

See page 8 in pack 9

Question 18

Draw a diagram to show the impact of contractionary monetary policy

Answer 18

See page 8 in pack 9

Question 19

What is contractionary monetary policy?

Answer 19

Contractionary monetary policy involves reducing aggregate demand using high interest rates, restrictions on the money supply and a strong exchange rate

Question 20

Define the term ‘money supply’

Answer 20

Money supply is the amount of spending power in an economy. It includes cash and bank deposits

Question 21

What are the short term and long term effects of increasing the money supply as an expansionary measure?

Answer 21

Printing more money as an expansionary measure is likely to boost aggregate demand in the short term but in the long term there is a risk of high levels of inflation, falling confidence and falling values of the currency on foreign exchange markets

Question 22

What are some of the effects of an increase in interest rates?

Answer 22

• Less borrowing
• Less consumer spending
• Less investment by firms
• Less confidence among consumers and firms
• More saving
• A decrease in exports
• An increase in imports

Question 23

Who are interest rates set by?

Answer 23

Interest rates are set by the monetary policy committee (MPC)

Question 24

What is the monetary policy committee (MPC)?

Answer 24

The monetary policy committee of the Bank of England sets interest rates in order to meet the inflation target of 2% set by the government as measured by the CPI

Question 25

By how much is inflation allowed to vary against the 2% target?

Answer 25

Inflation is allowed to vary by 1% either side of the 2% target

Question 26

What would the MPC do if they believed that inflation was likely to go over 3% with current interest rates?

Answer 26

The MPC would increase the official rate of interest called the base rate to reduce aggregate demand and keep inflation close to 2%

Question 27

What economic data will the MPC look at when making decisions about interest rates?

Answer 27

• House prices
• The size of any output gaps
• The pound’s exchange rate
• The rate of any increases or decreases in average earnings

Question 28

What are some of the benefits of monetary policy?

Answer 28

1- Interest rate changes can affect a range of AD components increasing its impact
2- Boosting the economy through lowering interest rates may be far cheaper than expansionary fiscal policy
3- It is more politically independent than fiscal policy meaning decisions are better informed with the interests of the economy as a priority
4- The rates are quite easy to change and can be adjusted each month unlike fiscal policy
5- It can manipulate AD and impact AS to some extent
6- It can help with cost push inflation to some extent

Question 29

What are some of the drawbacks of monetary policy?

Answer 29

1- There are time lags, for example it usually takes 2 years for the impact of an interest rate change to be fully felt. This requires accurate forecasts about the future which can be difficult to create
2- Success depends on other factors outside of the committee’s direct control such as confidence. If people are not confident they will not stop saving no matter how low the interest rate goes
3- A significant proportion of loans are now done on fixed interest rates meaning a change in the future in interest rates will not affect all loans
4- Interest rate changes affect the whole country. It is not possible to have different interest rates for different regions or industries which are struggling economically. Fiscal policy however can be pin-pointed to areas in need