Monetary Policy Flashcards
definition of monetary policy
monetary policy involves changes in interest rates, the supply of money & credit and exchange rates to influence the economy
Points of expansionary monetary policy (increasing AD)
- fall in nominal and real interest rates
- measures to expand supply of credit
- depreciation of the exchange rate
Points of deflationary monetary policy (decreasing AD)
- higher interest rates on loans and savings
- tightening of credit supply (loans harder to get)
- appreciation of the exchange rate
describe the transmission mechanism
official bank rate: market rates
asset prices - domestic demand
expectations/confidence- external demand
exchange rate -import prices
-total demand- domestic inflationary pressure
: domestic inflationary pressure + import prices -inflation
what does the transmission mechanism show?
the effect of interest-rate changes
3 LCR for rising interest rates leading to falling inflationary pressure: saving, borrowing, mortgages
IR rise- more expensive to borrow- less incentive to borrow- falling consumer spending- falling AD- falling inflationary pressure
IR rise- more reward for saving- greater incentive to save- falling consumer spending- falling AD- falling inflationary pressure
IR rise- rates rise on variable rate mortgages- falling consumer spending- falling AD- falling inflationary pressure
what is the main monetary policy objective?
controlling inflation
definition of interest rates?
an interest rate is the reward for saving and the cost of borrowing expressed as a percentage of the money saved or borrowed
what is inflation rate targeting?
when the MPC of the bank of England sets interest rates in order to meet the inflation target set by government (2%)
different types of interest rates:
- interest rates on savings in bank and other accounts
-borrowing interest rates
-mortgage interest rates (housing loans)
- credit card interest rates and pay-day loans
- interest rates on government and corporate
loans
what is the real rate of return on savings?
money rate of interest minus the rate of inflation
when do real interest rates become negative?
when the nominal rate of interest is less than inflation
price deflation can lead to what?
an increase in real interest rates
likely effects of an increase in interest rates: (a decrease will have the opposite effect)
- less borrowing
- less consumer spending
- less investment by firms
- less confidence among consumers and firms
- more saving
- a decrease in exports
- a increase in imports
a reduction in interest rates or an increase in the supply of money and credit is a what type of monetary policy?
expansionary monetary policy
what is expansionary monetary policy?
uses lower interest rates to increase aggregate demand and shift the AD curve to the right. designed to boost consumer confidence and demand during a downturn/recession
how a increase in interest rates decreases aggregate demand?
-higher interest rates reduce household consumption:
-ppl save, less income available for C
-cost of borrowing increases, increases of credit
card debt, less money to spend on C
-high IR, asset prices fall, reduce personal wealth,
reduces C
-falling house and share prices reduce consumer
confidence, deflates C
-higher interest rates reduce business investment
-higher borrowing costs make buying capital
goods unprofitable
-changes in interest rates affect exports and imports via exchange rate
-higher interest rate increases demand for
pounds, causes pounds exchange rate to rise,
UK exports less price competitive in world
markets and imports more competitive in UK
markets, UK BOP on current account worsens
impact of lower interest rates- demand side and draw diagram
-slow economic growth feed through to lower inflation may cut interest rates
-reduces savings ratio and makes borrowing more attractive so C rises
-increases real national output from Y to Y1
LRAS curve AD shifts to the right up curve from AD to AD1: creates employment
impact of lower interest rates- supply side and draw diagram
-may stimulate businesses investment into capital process to improve their productivity and efficiency: shift LRAS to LRAS1
-investment is a component of AD so AD shifts to AD1
-productive capacity increased to FE1 and increase in AD feed through to higher growth and employment
LRAS shifts to the right to LRAS1, AS moves up curve to right to AD1
what happens when people are pessimistic about future of the economy and prefer to hold onto their money and unlikely to borrow any more? what will lowering interest rates do and whats this an example of?
lowering interest rates wont have an effect and monetary policy will become ineffective. this is an example to liquidity trap
impact of higher interest rates LCR:
- raises interest rates
- tighter monetary policy
- market interest rates increase
- cost of borrowing rises
- main effect through mortgages
- possible slowdown in housing market
- contraction in retail credit
- higher rates might also cause currency appreciation
- makes UK exports more expensive in overseas market
- lower demand
- domestic inflation
- inflation
what is the bank rate?
the lowest rate at which the bank of England will lend to financial institutions. (ISNT rate of interest pay for mortgage or bank loan but they are linked)
if the bank rate goes up what does this usually lead to? (opposite for bank rates fall)
interest rates on mortgages and bank loans also increasing
what does hot money refer to, use an example?
when interest rates are high in UK, big financial institutions want to buy the pound. so can put money in uk banks and take advantage of high rewards for savers brought about by high IR- short-term movement of money
what does an increase in demand for the pound mean?
its price will go up
what does a high exchange rate make UK exports? and what happens to exports and bop?
exports more expensive. exports go down, worsening the current account on the BOP
what does high interest rates mean for imports and current account? what happens to ad?
high IR mean imports from abroad are cheaper and worsens current account. imports are a leakage in circular flow of income, more spending on imports means a reduction in AD
what happens when UK interest rates fall? (exchange rate)
exchange rate of pound falls
UK exports increase (Uk goods get cheaper)
imports decrease (foreign goods get expensive)
balance of payments improves
definition of exchange rate?
rate at which one currency trades against another on the foreign exchange market. the purchasing power of one currency against another
when does liquidity trap occur?
when low interest rates and a high amount of cash balances in the economy fail to stimulate aggregate demand
reasons for liquidity trap:
- risk averse commercial banks: required to hold more capital, risk premium on new loans
- private sector businesses and consumers: low on confidence, focused on cutting debt
monetary policy evaluation:
- time lags should be considered when analysing effects of interest rate changes
- not an exact science- businesses and consumers don’t always behave in standard way
- does not work in isolation
- objectives can change
- many factors affect costs and prices which can change inflation risks in a country
what is contractionary monetary policy?
uses higher interest rates to decrease aggregate demand and to shift the AD curve to the left (SRAS)
what is quantitive easing?
an expansionary monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to stimulate the economy and increase liquidity
when is quantitative easing used?
when its necessary to adopt a ‘loose’ monetary policy to stimulate aggregate demand (or create upward pressure on inflation) at a time when interest rates are already very low
what does QE increase?
increase the money supply which will enable individuals and firms to spend more
using QE to bring up the rate of inflation has the benefit of what?
it keeps a currency weak which can increase the competitiveness of an economy and boost exports
QE provides a boost to what?
overall confidence in an economy as consumers and firms see the central bank taking action
One danger of using QE:
financial institutions may initially use this new money to increase their reserves, and only lend it out when the economy improves. this extra lending at a time when inflation may be increasing can lead to demand-pull inflation becoming harder to control
what is helicopter money?
a form of monetary policy in which a central bank prints money and distributes it directly to households/consumers
what is the purpose of helicopter money?
- increase money supply
- target higher inflation
- increase aggregate demand in the economy when conventional monetary policy has failed
difference between QE and helicopter money?
- helicopter money goes directly to households and consumers rather than banks and financial institutions who sell bonds to the central bank
- helicopter money is non-reversible
disadvantages to helicopter money?
- inflation could increase more than expected
- central bank could loose inflation creditability
advantages to helicopter money?
- greater impact on boosting spending and aggregate demand than QE
- can target higher inflation which helps to avoid problems related to deflation and debt deflation
- better distribution
ways to manipulate exchange rate:
- buying or selling currencies on the foreign exchange market
- through interest rates, which affect demand and supply of sterling via their effect on inflows of hot money
- some currencies are subject to exchange controls by the relevant national central bank
describe a free-floating currency:
- value of a currency is determined by purely demand and supply of the currency
- most currency dealing is speculative but trade and investment decisions have a role to play
describe a fixed exchange rate system:
- the exchange rate is pegged and there are no fluctuations from the central rate
- a country can automatically reduce its competitiveness by reducing its costs below that of other countries
describe and define a managed-floating currency
when the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives
- value of currency is determined by market demand for and supply of the currency
- big fluctuations in the external value of a currency can increase investor risk and perhaps damage business confidence
factors affecting exchange rate:
-interest rate differentials
-trade balances:
-recession in trading partner-causes fall in export
sales- worsening of trade balance- inward shift of
currency demand- currency will depreciate
-economic growth
-inflation
-confidence in the economy/currency
-foreign direct investment
-portfolio investment
impact of depreciation: on improved balance on current account following a depreciation if demand for import and export are price elastic
import:
price-rise
sales volume-fall fall
sales value- fall
export:
price-fall
sales volume- rise rise
sales value-rise
impact of depreciation: on worsened balance on current account following a depreciation if demand for import and export are price inelastic
import:
price-rise rise
sales volume-fall
sales value- rise
export:
price-fall fall
sales volume- rise
sales value- fall
impact of appreciation: on worsened balance on current account following an appreciation if demand for import and export are price elastic
import:
price-fall
sales volume- rise rise
sales value- rise
export:
price-rise
sales volume- fall fall
sales value- fall
impact of appreciation: on improved balance on current account following an appreciation if demand for import and export are price inelastic
import:
price-fall fall
sales volume- rise
sales value- fall
export:
price-rise rise
sales volume- fall
sales value- rise
a currency appreciation makes exports what?
more expensive and likely to lead to an inward shift of AD
a currency appreciation makes imports what?
cheaper and likely to cause an outward shift of AS
