Monetary Policy

Question 1

What is monetary policy?

Answer 1

Monetary policy refers to the use of interest rates to control spending in an economy. They are set by the Bank of England in England. (The BoE)

Question 2

What is operational independence? (The BoE)

Answer 2

Operational independence is what the BoE have. It means they have complete freedom to set interest rates, however they have to use this freedom to achieve the governments target of 2%, + or - 1%

Question 3

What are the consequences of negative inflation?

Answer 3

In inflation is low, it could lead to a deflationary spiral, leading to a recession.

Question 4

What are The Bank of Englands main roles?

Answer 4

The BoE sets the interest rates. It has 3 main roles:

1) To use interest rates to achieve the governments inflation target
2) To ensure the stability of the financial system as a whole - such as setting restrictions on what banks are able to do, e.g. amount of cash they can hold
3) To act as lender of last resort to the banking sector. - In the Short term, if any of the banks need money they can always go to the BoE.

Question 5

What is a symmetrical target? And what happens if the BoE fails to achieve its target?

Answer 5

A symmetrical inflationary target means a target is controlled if it is too high or too low.

If the BoE fails to achieve its target, it has to write a letter to the government explaining why it has failed and what they intend to do next. The BoE does not want to do this as it undermines their credibility.

Question 6

What are the 3 operations of monetary policy?

Answer 6

1 - Controlling Interest rates

2 - Quantitive easing

3 - Direct controls on the banks

Question 7

What does the control of interest rates entail?

Answer 7

The objective is to control spending in the economy. If the BoE is worried inflation will be above its target, it will increase interest rates, and if below target it will reduce interest rates.

Question 8

What is Quantitive Easing? (QE)

Answer 8

QE is where the BoE deliberately buys financial securities from the various money markets, e.g. Government bonds. This will increase the amount of cash held by the banks, meaning the banks can loan more, helping to boost spending in the economy.

Question 9

What is the effect of increasing interest rates?

Answer 9

The effect of higher interest rates will be to reduce spending in the economy by making it more difficult for businesses to sell their goods and putting more pressure on them to reduce prices, which will help bring inflation down.

Question 10

Why would higher interest rates tend to reduce spending?

Answer 10

Interest rates tend to reduce spending because:

• It Encourages people to save their income because it has a higher opportunity cost now
• It will tend to reduce the amount people spend on credit as borrowing is more expensive
• It will increase the cost of peoples mortgages
• Businesses will tend to spend less on investment. This also has a negative multiplier effect
• It ((MIGHT)) lead to an increase in the exchange rate

Question 11

Why ((MIGHT)) an increase in interest rates, which tend to reduce spending, increase the exchange rate?

Answer 11

Because it might attract more foreign investors to invest/save more in the UK, increasing the demand for the pound, increasing the exchange rate. (Supply and demand of pounds diagram)

This reduces inflation because:
1 - It makes exports more expensive, so demand will fall, reducing spending in the economy and having a negative multiplier effect

2 - If the exchange rate goes up, imports are cheaper, lowering business costs and reducing cost-push inflation

Question 12

How long does it take the use of monetary policy to reduce spending?

Answer 12

In practice, it tends to take around 18 months for all these changes to fully effect the economy. This means when the BoE changes interest rates to affect inflating its predicting where inflation will be in 19 months.

HOWEVER, the future is always uncertain.

Question 13

What factors does the BoE take into account when changing interest rates? (This is a popular question)

Answer 13

1 - The current level of inflation
2 - The level of unemployment (If too low, inflation may be expected)
3 - Growth of GDP (Worry of a boom)
4 - The level of the exchange rate (Affects businesses costs)
5 - The level of consumer spending
6 - The level of wage increase (Inflationary expectations)
7 - The level of energy prices and raw materials

Question 14

Why was Quantitive Easing particularly important during the 2008 banking crisis?

Answer 14

In 2008:

• The economy was in a recession
• The BoE interest rates where reduced from 5% to 0.5%
• Most banks had gone bust, so they had no money to lend out
• Because of QE, banks had cash to lend out

Question 15

What are the problems of Quantitive Easing?

Answer 15

There are four main problems. These are:

1) In the short term, its very expensive, and there’s a limit to borrowing
2) In a recession, there is no guarantee it would work, as consumer confidence is still low and unemployment is high.
3) There is a risk the government will overdo it, leading to higher inflation according to the Quantitive theory of money (MV = PT)
4) This policy tends to benefit the rich, by increasing the value of their stocks/bonds as demand increases.

Question 16

How would the BoE reduce spending using QE?

Answer 16

They would simply reverse the prices i.e. Sell the assets to the banks, reducing the amount of cash they have, reducing lending, ∴ reducing spending in the economy.

Question 17

What are the direct controls on the banks? (3)

Answer 17

1 - Set a maximum amount of money the banks are allowed to lend out

2 - Introducing rules about how banks can lend their money out e.g. require people to pay a bigger deposit for their mortgate

3 - Make the banks hold more cash (relative to the number of customers). There more cash they hold, the less they can lend out.

Banks do not like these measures because it limits what they can do.

Question 18

What are the problems with monetary policy? (3)

Answer 18

(1) Time lag (18 months) means interest rate decisions have to be based on what will happen in the future, which is always uncertain, so they might get it wrong
(2) Changes in interest rates are likely to lead to tradeoffs between the different objectives. For example, if they increase interest rates to reduce inflation, that will tend to slow the growth of the economy and increase unemployment.
(3) Usually, increases in interest rates are much better at reducing spending (In a boom) than decreases are at increasing spending during a recession. This is because people still have concerns about unemployment during a recession