Monetary Policy Flashcards
What does monetary policy involve making decisions about?
- Interest rates
- monetary policy (QE, Money supply)
- exchange rates
What does expansionary monetary policy involve?
Lowering the base rate of interest
When the base rate is lowered, what will this effect?
lowering of:
- credit card interest rates
- savings rates
- mortgage rates
- business loans
- weakening exchange rates
What is the chain of analysis for lower credit card interest rates?
- decreased credit card rates
- incentivises borrowing / less saving
- increases consumers’ MPC
- increases spending on expensive goods
- increased consumption
- increased AD
What is the chain of analysis for lower savings rates?
- disincentivises savings / less borrowing
- consumers will spend more (increased MPC)
- increased consumption and AD
What is the chain of analysis for lower mortgage rates?
- tracker and variable mortgage rates will fall
- households will have more disposable income
- increased C and AD
What is the chain of analysis for lower business loan rates?
- increases business borrowing
- increases investment
- increases AD
What is the chain of analysis for weakened exchange rates?
- saving domestically becomes less attractive
- hot money outflows
- increases the supply of the pound which will lower the ER
- WPIDEC
- increased trade surplus
- increased AD
What effect will expansionary monetary policy have on inflation?
Due to the rightward shift in AD, if the economy is close to full employment, we will see demand pull inflation.
This may be desirable if the economy is below the inflationary target.
What else can we see from the increase in AD?
increase in real GDP
- increased growth
- reduced unemployment
When will expansionary monetary policy increase LRAS?
When investment increases, due to lower business loan rates, we will see improvements in the capital stock and an increase in the productive capacity of the economy (LRAS shift right)
What are the disadvantages of expansionary monetary policy?
Trade off with inflation when growth and a fall in unemployment occurs. May end up overshooting the inflationary target.
Current account deficit
- growth increases - household incomes rise and MP to import will rise worsening the current account deficit
Negative impact on savers
- if inflation is higher than the nominal interest rate then savings will lose value (return on savings is negative)
- potential for households to not save. This could be dangerous as if unemployment rises, we may see people-without-savings’ standard of living falling
time lag - takes a long time for an interest rate cut to fully feed through the economy
liquidity trap
Describe the ‘liquidity trap’
- Interest rates have a lower bound
- Once interest rates are low enough, consumers and business will have already liquidated all of their assets into cash for safe-keeping, or facilitating spending or investment due to uncertainty about the future
- If interest rates are cut further, it will have no effect as borrowing will not be demanded anymore due to everyone’s liquidity.
What does the effectiveness of monetary policy depend on?
- Size of the output gap
- large output gap (recession), large increase in growth
- small output gap, smaller impact on growth however larger demand pull inflation - Consumer confidence
- consumers must be confident in order to borrow and spend - Business confidence
- businesses must be confident about the future of the economy, prospect on demand for their products and profitability in order for them to invest - Banks willingness to lend
- due to potential financial or banking crisis, banks will hoard for security and borrowing will be less possible - Size of the rate cut
- larger the cut, larger the effects
