Macro Unit 7- Monetary Policy

Question 1

What does monetary policy involve?

Answer 1

Making decisions about interest rates which can influence consumer spending, investment, housing and savings

Question 2

How do you control the flow of money?

Answer 2

• increase or decreasing interest rate
• exchange rate policy- government can’t influence exchange rates
• Quantitative easy
• Intervention

Question 3

Is the monetary policy demand or supply side?

Answer 3

Demand side policy- affects AD

Question 4

What is contractionary policy?

What is expansionary?

Answer 4

Contractionary- decreases ad to control inflation

Expansionary- increase AD

Question 5

Who sets the interest rates?

What’s the target for inflation?

Answer 5

Bank of England

2%

Question 6

The official date set by the BoE is called the base rate. It is not controlled by the government because

Answer 6

It’s needs to be impartial from politics

Question 7

What is the money supply?

Answer 7

Money supply means the amounts of notes and coins in circulation, plus the amount of money held in bank accounts.

Question 8

What is quantitative easing?

Answer 8

Quantitative easing is used when it is necessary to stimulate AD at a time when interest rates are already very low and ant go lower. It increases the money supply which will enable firms to invest and consumers to consume more.

Question 9

Why does increasing the money supply need to be used with caution?

Answer 9

Because increasing the money supply to much could cause excess inflation resulting in very high price levels

Question 10

What does it means to tighten the rule on credit

Answer 10

They will have the effect of constraining investment and consumption by making bank loans and mortgages harder to obtain.

Question 11

What happens to bank loans and mortgages when there is a contractionary policy

Answer 11

Bank loans and mortgages are harder to obtain causing a contractionary policy to occur- general spending will decrease due to more people saving

Question 12

What does it mean to loosen the rules on credit ?

Answer 12

Loosening the rules on credit means it will improve the availability of credit and make it easier to obtain loans and mortgages- expansionary policy

Question 13

Explain how high interest rates leads to a strong pound?

What impact does this have on AD?

Answer 13

If the U.K. raises interest rates, then investors will move their money to the U.K. in order to get the best return. This means they will have to sell their dollars and buy pounds top deposit in the U.K. This increased demand for U.K. pounds increases the exchange rate SPICED. Our exports become less competitive and so We will import more. AD will decrease.

Question 14

Where does the ‘new money’ for QE come from and what is it used to buy?

Answer 14

A central bank operates QE by creating new money in the central banks own current account. The central bank buys assets, usually government bonds, with money it has ‘printed prices more accurately creates deterously. This new money is used to buy assets such as give government bonds, houses etc.

Question 15

What is the aim for QE?

How do they achieve this?

Answer 15

To inject liquidity at the financial markets and push up asset prices by increasing demand for assets

As the banks sells assets to the central bank this increases the amount of cash in the financial system encouraging financial institutions to lend more to businesses and individuals

Question 16

How does QE lower interest rates?

Answer 16

Banks take the new money and buy assets to replace the ones they have sold to central banks. That raises stock prices and lowers interest rates, which in turn boosts investment.

Question 17

What is a yield?

Calculation?

Answer 17

By buying assets such as government bonds, this creates higher bond prices which then causes bond yields. A yield is a figure that shows the return you get on a bond.

Yield= coupon amount/price

Question 18

How can QE lead to an inflation problem?

Answer 18

Increase in prices too much, partly due to lower interest rates, can cause inflationary pressure.

Question 19

What do low interest rates mean for our currency?

Answer 19

WIDEC- depresses the value of a currency because it becomes less attractive to foreign investors.

Question 20

When the bank buys assets, what happens to the price of assets?

Answer 20

It increases their price and so reduces their yield- that means the return on those assets fall.

Question 21

What does lower yield lead to?

Answer 21

Lower yield reduces the cost of borrowing for businesses and households. This in turn leads to higher consumer spending and more investment.

Question 22

How does this extra money injected into the economy boost the economy?

Answer 22

It should increase spending to help keep inflation on track to meet the governments 2% target.

Question 23

If inflation is set to rise above target, what will they do?

Answer 23

If the committee thinks inflation looks to rise above target, it could raise bank rate, and sell assets to remove the extra money it has put into the economy.

Question 24

At what point are interest rates ineffective?

Answer 24

If interest rates are almost at zero then they may be ineffective.

Question 25

What is having ‘liquidity’ and the impact of this?

Answer 25

Banks can lend money as they have plenty of cash and so banks and people who use banks will feel more confident.

Question 26

What are the arguments supporting QE being useful?

Answer 26

• When inflation rates are low
• Fall in bond yields-Reduces cost of government borrowing and fall in mortgage interest rates- stimulate the housing market- wealth effect (shift AD out)
• During a recession
• Currency to depreciate (WIDEC)- more injections and exports more competitive- shifts AD out- employment and confidence

Question 27

What are the arguments against QE being useful?

Answer 27

• Hard to measure-Long term impacts aren’t known
• Not guaranteed to lead to rising bank loans to consumers and businesses- limit the improvement- AD shifts a tiny bit-costly- low confidence
• House prices are increasing from low interest rates and bond yields- debt (false consumption)
• Relative to strength of other countries
• Fuels asset bubbles due to very low interest rates-house prices are becoming increasingly overvalued- encourages household and firm debt- false confidence which could cause a false boom

Question 28

What is quantitative tightening?

Answer 28

It is a contractionary monetary policy applied by a central bank to decrease the amount of liquidity within the economy. The policy is the reverse of QE aimed to increase money supply in order to ‘stimulate’ the economy.
Instead of buying bonds, you sell them. In effect, this is burning money, rather than printing it.

Question 29

What is the Central banks responsibility?

Answer 29

Maintaining monetary stability- low inflation, positive economic growth and financial stability e.g. acting as a lender of last resort should commercial banks be short of funds

Question 30

Explain a possible long-term impact of the central bank stepping in to directly lend money, especially to enterprises?

Answer 30

Business could go insolvent (liquidation) and so the central bank would lose money.

Question 31

Define direct intervention

Why is direct intervention used?

Answer 31

Direct intervention is a foreign exchange transaction that are conducted by the monetary authority and aimed at influencing the exchange rate.

It leads to higher rates of growth

Question 32

What is a floating exchange rate?

Answer 32

A managed floating currency when the central bank may choose to intervene in the foreign exchange markets to effect the value of a currency to meet specific macroeconomic objectives.

Question 33

What are some negative impacts on the economy from manipulating the exchange rate as seen in 1990-1992?

Answer 33

1. Printing money tends to be inflationary- higher inflation makes a country less competitive leading to relatively lower demand for their exports and hence currency
2. Increasing the money supply enables the central bank to buy foreign currency, which drives down the value of the domestic currency
3. Speculative demand- by promising to print money and keep currency low, it discourages speculators from buying that currency as it is less likely to be a good bet.

Question 34

How can printing money (QE) be used as part of currency manipulation?

Answer 34

It can be difficult to strengthen the currency if markers don’t agree it is worth that much (WIDEC). A central bank can try to increase interest rate however this usually attracts hot money flows to take advantage of better rates of return leading to higher value of currency.

Question 35

A depreciation is a drop in the external value (WIDEC) is caused by?

Answer 35

• Cut interest rates- cause an outflow of hot money from the banking system and an increase in currency flowing overseas seeking a better return
• Sell yours country’s own currency and buy foreign currencies- increased market supply of the domestic currency and a fall in the exchange rate (WIDEC)- Rise in foreign reserves

Question 36

What does the financial sector refer to?

Answer 36

The financial sector is a section of the economy made up of firms and institutions that provide financial services to commercial and retail customers. The sector comprises a broad range of industries including banks, investment companies, insurance and real estate etc.

Question 37

What are 2 key benefits of the size and scale of the UK financial sector to the UK economy?

Answer 37

1. Jobs

2. Trade surplus

Question 38

Outline 3 possible consequences of BREXIT on the financial sector in the UK?

Answer 38

1. Access to the single market- may be reduced
2. Trade deals on goods and services may be poor
3. If the status/representation of the country is lost then foreign companies may move out of the country to locate elsewhere

Question 39

What are banks?

Answer 39

Banks (e.g. high street banks) provide some of the core services of a financial system, including holding deposits from the public and creates credit, providing payment services and lending to households and companies.

Question 40

What are nonbanks?

Answer 40

Non-banks (e.g. pensions and life insurance) are financial institutions that are not considered full-scale banks because they do not offer both lending and depositing services.

Question 41

What is the Financial Conduct Authority (FCA)?

Answer 41

The FCA regulate the way banks treat money and the criteria they use for lending and dealing with complaints. The FCA regulate areas such as:

1. Market abuse- abusing monopoly power
2. Insider trading- companies use inside knowledge to make personal gains
3. Customer data security
4. Liquidity risk- are banks lending inappropriately

Question 42

What is the purpose of regulation of the financial sector?

Answer 42

Financial regulation is the supervision of financial markets and institutions. The primary purpose of a financial regulation is to maintain the integrity investors maintain orderly markets and promote financial stability.

Question 43

How can regulation avoid a crisis like the 2008 recession?

Answer 43

Following the 2008 credit crunch, banks are now regulated by the Financial Conduct Authority which regulates the way banks treat money and the criteria they use for lending and dealing with complaints.

Question 44

What is an asset bubble?

Answer 44

An asset bubble is when the price of an asset such as housing, stocks or gold become over-inflated. Prices rise quickly over a short period. They are NOT driven up by demand for the product itself. It’s a bubble when investors continue to bid-up the price beyond any real, sustainable value. Their prices are well above long run sustainable levels. Prices can be driven because expectations of future price increases bring new buyers into the market.

Question 45

Causes of that increase in housing demand leading to a bubble are:

Answer 45

• An increase in the population entering the housing market- inelastic good
• An upturn in economic activity and prosperity that put more disposable income in consumers’ pockets and encourages home ownership
• A low, general level of interest rates
• Innovative mortgage products with low initial monthly payments that make homes more affordable
• Easy access to credit (borrowing)
• Poor estimation of risk by mortgage lenders and mortgage bond investors that expands the availability of credit to borrowers
• A lack of financial literacy and excessive risk-taking by mortgage borrowers- unaware of the risks, interest rates-information asymmetry.
• Speculative and risky behaviour by home buyers and property investors

Question 46

What impact does the following have due to asset bubbles:

1. Consumers
2. Firms
3. Government

Answer 46

1. Information asymmetry- consumers do not understand negative consequences of more spending when their is low interest rates which is allowing higher prices costing consumers more
2. Firms- firms related to the UK property market continue to increase their prices as investors are continually bidding beyond any real sustainable value.
3. Government- start considering interest rate levels carefully as with high mortgage rates customers will start having to use savings which will reduce consumption elsewhere in the economy.

Question 47

How can policies used by the government to help the economy recover from an asset bubble create another in the long run?

Answer 47

Lower interest rates will cause propensity to spend to be higher than the propensity to save-consumption increases-inflation-cause another asset bubble

Question 48

What is mean reversion?

Answer 48

The law of finance says that markets that go through periods of rapid price appreciation or depreciation will in time revert to a price point that puts them in line with their long term average rates of appreciation indicate they should be.

Question 49

What is a bitcoin?

Answer 49

A digital currency that is not backed by any country’s central bank or government that was created in 2009. Bitcoin can be traded for goods or services with vendors who accept bitcoins as payment. Bitcoin offers the promise of lower transaction fees than traditional online payment mechanisms and is operated by a decentralised authority. There are no physical bitcoins, only balances kept on a public ledger in the cloud that is verified by a massive amount of computing power. They are not issued or backed by any banks or governments.

Question 50

How is a bitcoin considered to be an asset bubble?

Answer 50

1. Some say bitcoin isn’t tangible- its a decentralised currency meaning no one government would back it up
2. Overhyped and inflated beyond measure
3. Few people bought it to use it, they just wanted to buy it low and sell it high
4. Governments decided to sanction and tax its usage and some banning the ‘currency’ due to its volatility.

Question 51

What are Britain’s prices influenced by?

Answer 51

1. The supply of bitcoin and market demand for it
2. The cost of producing bitcoin throughout the mining process
3. The rewards issued to bitcoin miners for verifying transactions to the blockchain
4. The number of competing cryptocurrency
5. The exchange it trades on
6. It’s internal governance
7. Regulations governing its sale

Question 52

What caused the bubble to burst for bitcoin?

Answer 52

• Refusal of the US regulators to approve a number of Exchange Trade Funds based on bitcoin due to concerns over the security of exchanges
• The increasing cost of mining the larger currencies, various warnings form central banks and a wave of selling among cryptocurrencies
• Competition was fierce
• A strong brand name wasn’t enough- it wasn’t the best performing - not the most effective with speed of transactions compared to credit card transactions.