Monetary Policy

Question 1

What is Monetary policy?

Answer 1

Change to interest rates, the money supply and the exchange rate by the CENTRAL BANK in order to influence AD

Question 2

Monetary policy: is the central bank and/ or government decisions on…

Answer 2

• Rate of interest
• Money supply
• Quantitative easing
• Inflation rate targets
• The exchange rates

Question 3

Government set goals and…

Answer 3

…central banks try to achieve them through monetary policy

Question 4

What are Interest rates?

Answer 4

Essentially the price of money. It is the price we pay to borrow money

Question 5

If the base rate rises…

Answer 5

…banks increase the interest rates they charge customers

Question 6

What effect could an increase in interest rates have?

Answer 6

• Reduced investment
• Reduced consumption
• Reduced exports - imports (worsening BoP)

Question 7

What effect could a decrease in interest rates have?

Answer 7

• Increased investment
• Increased consumption
• Increased exports - imports (Improved BoP)

Question 8

What term is used for a decrease in interest rates?

Answer 8

Expansionary monetary policy

Question 9

What is Money supply?

Answer 9

The total amount of money in circulation or in existence in a country

Question 10

What are Reserves?

Answer 10

The money that the banks have in their account at the Bank of England

Question 11

What are Bank deposits?

Answer 11

Banks create around 80% of money in the economy as electronic deposits - this is money they create (make up) in giving out loans to businesses and individuals

Question 12

How is money supply altered?

Answer 12

The main way that money supply is changed is by the ordinary banks issuing more or less loans to its customers

Question 13

An increase in money supply, more bank loans meaning…

Answer 13

C and I both increase, both components of AD, increasing AD, shifting AD to the right

Question 14

Decrease in the money supply, less banks loans meaning…

Answer 14

C and I both decrease, both components of AD, decrease AD (growth), shifting AD to the left

Question 15

Way to increasing the money supply?

Answer 15

Quantitative Easing

Question 16

What does QE do?

Answer 16

Increases the money supply by the central bank electronically creating money.
Use the money to buy bonds held by banks and other financial institutions

Question 17

Once the central bank buys bonds from financial institutions they become liquid, why?

Answer 17

They are holding cash (given to them by the central bank) instead of bonds which the banks have sold to the Central Bank

Question 18

What does buying bonds from banks do?

Answer 18

1) Reduces interest rates
2) Leading to businesses and consumers borrow more
3) Spending increases and more jobs available
4) Boost the economy

Question 19

If the UK base rate (interest rate) goes up…

Answer 19

…so does the strength of the pound

Question 20

If the UK base rate (interest rate) goes down…

Answer 20

…The pound goes down

Question 21

What does the change in interest rate cause a change in the exchange rate?

Answer 21

Main factor determining this is speculation - business and investors moving money around the world. This is called HOT MONEY

Question 22

If the UK raises interest rates, what will happen?

Answer 22

Speculators can get more return by keeping their money in the UK. Move money to the £, increasing the demand for £ and therefore the price of the £

Question 23

Relationship between interest rates and exchange rates?

Answer 23

Tend to move in the same direction

Question 24

How do the Bank of England influence the amount of money banks create?

Answer 24

1) Regulate the banks-set minimum levels of balances that have to hold
2) They can manipulate the interest rate

Question 25

What is the inflation target for the UK?

Answer 25

2% The Bank must ensure that the inflation rate is never more than 1% below or above this

Question 26

Why 2% as the target for inflation?

Answer 26

• 2% is stable
• UK economic growth is expected to be in the region of 2%, prices rising by 2% is not unreasonable
• 2% inflation is pretty low, UK exporter remain competitive
• This allows X to increase, shifting AD to the right and supporting the governments other objectives of economic growth and low unemployment

Question 27

Main strength of Monetary policy?

Answer 27

BoE independent; usually done for social economic reasons. MP is the only real method of controlling the PL

Question 28

Main weakness

Answer 28

Time lag. MP can take a long time to affect the decisions of the groups it is trying to target. Businesses and households don’t make big investment or house buying overnight. Constrained by the liquidity trap

Question 29

The Liquid Trap

Answer 29

When no-one wants to borrow , invest, they want to hang onto their cash if the interest rate is dropped even more this won’t be effective in promoting economic growth

Question 30

What can monetary policy both be?

Answer 30

Contractionary monetary policy - reduce AD

Expansionary monetary policy - increase AD

Question 31

What are some of the reasons why EXPANSIONARY MONETARY POLICY?

Answer 31

1) Hit the inflation target, if below target. Boost AD and raise demand-pull inflation
2) Increase Growth
3) Reduce unemployment

Question 32

What are some of the reasons for CONTRACTIONARY MONETARY POLICY?

Answer 32

1) If inflation is beyond target a reduction in AD can reduce demand-pull inflation bring to target rate
2) Prevent excessive growth in house prices, prevent excessive credit - borrowing by households - risk to the financial secto and potential crash if this continued
3) Promote saving as interest rates increase, reduces borrowing.

Question 33

Explain the process of EXPANSIONARY monetary policy Transmission Mechanism?

Answer 33

• Decrease in credit card interest rates leads to increase in C
• Decrease in saving rates leads to increase in C
• Decrease in mortgage rates leads to increase in C
• Decrease in rates on business loans leads to increase in I

Question 34

Evaluation for MONETARY POLICY

Answer 34

• Size of the output gap
• Consumer and business confidence to lead to a major impact of MP
• Size of the rate cut

Question 35

Explain the whole process of QE?

Answer 35

1) CB create money electronically
2) Money used to buy government bonds from the financial sector
3) P of govt bonds INCREASE due to increase in demand for govt bonds and yeild (interest rate) DECREASES
4) Banks either loan money or invest in shares or corporate bonds (due to low confidence)
5) P of corporate bonds INCREASE and yeild (IR) DECREASE making it easier to issue loans
6) Access to credit is easier, loads of money flying in the corporate bonds market, issue more CB leads to finance, cheaper to raise finance as interest rates are LOW
7) Willingness to lend INCREASES stimulating borrowing, leads to consumption increasing. AD increasing