MACRO - monetary policy

Question 1

what is monetary policy

Answer 1

Monetary policy is used to control the money flow of the economy, using a wide range of policy tools, conducted by the independent Bank of England

Question 2

what does the central bank manipulate

Answer 2

The central bank takes action to influence the manipulation of:
➔ Interest rates
➔ The supply of money/credit
➔ The exchange rate

Question 3

what is the role of the MPC

Answer 3

the Monetary Policy Committee (MPC) alters interest rates to control the supply of money

They are independent from the government, and consist of 9 members who meet 8 times a year to discuss what the rate of interest should be

Question 4

what is the role of interest rates

Answer 4

Interest rates are used to help meet the government target of price stability and a 2% inflation rate, since it alters the cost of borrowing and reward for saving

Question 5

what does the bank control

Answer 5

The bank controls the base rate, defined as the interest rate set by central banks for lending to other banks.

This is used as a benchmark for interest rates set by commercial banks.

Question 6

what are functions of a central bank

Answer 6

• The central bank manages the currency, money supply and interest rates in an economy. For example, the European Central Bank (ECB), and the People’s Bank of China are all central banks.
• they issue physical cash (notes and coins) securely and use methods to prevent forgery, so people trust the money
• The central bank can regulate bank lending to ensure there is stability in the financial system.

Question 7

what is the role of the bank to the government

Answer 7

• The central bank provides services to the Central Government collecting /making payments to/ on behalf of the governments
• It maintains and operates deposit accounts of the government
• The central bank also manages public debt and issues loans.
• Also advises the government on finance, eg timing/ terms of new loans

Question 8

what is an alternative role of the bank of england

Answer 8

• The Bank of England is considered to be a lender of last resort. If there is no other method to increase the supply of liquidity when it is low, the BoE will lend money to increase this supply.
• If an institution is close to collapsing, the bank might lend bc they have no other way to borrow

Question 9

how is bofe being a last resort beneficial

Answer 9

• it can protect individuals who deposit funds in a bank and might otherwise lose them
• also aims to prevent a ‘run on the bank’, which is when consumers all withdraw their bank deposits at once in a panic, because they believe the bank will fail

Question 10

what does borrowing from bofe suggest

Answer 10

banks will avoid borrowing from the lender of last resort, because it suggests to the government that the bank is experiencing financial difficulties and won’t display confidence to their depositors

Question 11

how does reducing interest rates affect saving (consumer spending C)

Answer 11

Low interest rates reduces the opportunity cost of saving, because it is cheaper for consumers to borrow from commercial banks

Question 12

how does reducing interest rates affect house buyers and owners (consumer spending C)

Answer 12

—> Households with variable rate mortgages benefit through lower repayments, which increases disposable income = increases their marginal propensity to consume.
—> Lower base rates (and therefore interest rates) increases number of mortgages taken out by households = demand for houses rises.
—> Due to housing supply in UK being PES inelastic = proportionately larger increase in house prices
—> This triggers a positive wealth effect. people spend more as they feel richer, boosting C

Question 13

how does reducing interest rates affect investment (I)

Answer 13

• Low interest rates = cheaper for firms to borrow from commercial banks, and use these cheap loans to fund R&D/other forms of investment.
• Investment also increase if consumer spending does, according to Samuleson’s accelerator effect, as investment is a derived demand.

Question 14

how does reducing interest rates affect government spending (G)

Answer 14

Low interest rates = government debt repayments will be lower = encourage
the government to issue more bonds to contribute to higher levels of government spending

Question 15

how does reducing interest rates affect exports - imports (X-M)

Answer 15

• Interest rates affect the amount of hot money flowing into an economy: money that flows from different countries in search of the highest interest rates to maximise short-term profits.
• So low interest rate would reduce the flow of hot money into the economy, as the rate of return is lower than in other countries.
• = weakens the exchange rate, as it increases the supply of the £ on FOREX markets - or decreases the demand for the £
• = increases the price competitiveness of exports, = 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.

Question 16

what is quantitive easing

Answer 16

Used by banks to help 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.

Question 17

what is the second step in quantitative easing

Answer 17

• banks now have more money = lend more to households and firms = increasing overall demand which will restimulate the economy

However, this assumes banks will not sit on the extra cash the BoE offers them, as concerned about their clients’ abilities to repay loans, like the 2008 Great Financial Crisis (GFC)

Question 18

what is the third step in quantitative easing

Answer 18

• Now central bank has bought up government bonds (gilts) = government has 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.

Question 19

what is an alternative approach of quantitative easing

Answer 19

Alternatively, if BoE wants to initiate in contractionary monetary policy, they will stop the purchase of government and bank bonds = banks will hold back on lending to consumers, governments will delay spending on infrastructure, R&D, etc = will overall reduce the rate of inflation to the BoE’s target of 2% CPI

Question 20

what is the first limitation of quantitative easing

Answer 20

As supply of £ increases = UK experiences depreciation of its currency on FOREX markets
Although = exports cheaper, imports become more expensive, because the UK imports a lot of raw materials from overseas = trigger cost-push inflation

Question 21

what is the second limitation of quantitative easing

Answer 21

QE lowers long-term interest rates (on bonds), bc supply of money has increased
= bonds less attractive to potential investors, due to lower return rate of return, so without anyone buying government bonds = less investment in the country = prevents the productive capacity of an economy from expanding.

Question 22

what is funding for lending

Answer 22

worsening conditions in the Euro area meant that UK banks were faced with higher funding costs.
to support them, the government introduced the Funding for Lending Scheme, —> aimed to lower these costs and provide cheap funding to banks and building societies.

Question 23

what is forward guidance

Answer 23

used by central banks to detail what the future monetary policy will be to the public.

with intention of reducing uncertainty in markets.

For example, MPC might state keeping interest rate at certain level until specified date

Question 24

what is an example of forward guidance

Answer 24

Janet Yellon, the former chair of the Federal Reserve, was a strong advocate of forward guidance, and always put it to practice in her years at the central bank.

She supported the idea as it reduced the levels of uncertainty amongst investors.

Question 25

what are factors considered by the MPC when setting bank rate

Answer 25

— Unemployment rate: if high, consumer spending likely to fall; MPC will drop interest rates to encourage spending
— Savings rate: a lot of saving = less spending, interest rates might fall
— Consumer spending: high level of spending = could be inflationary pressures = cause the MPC to increase interest rates
— High commodity prices: UK is a net importer of oil, high price could = cost-push inflation, pushing MPC to increase interest rates, overcome this inflationary pressure
— Exchange rate: weak pound cause the average price level to increase = makes UK exports relatively cheap, so UK exports increase.