Monetary Policy Flashcards
What is the Bank of England’s main targets
Bank’s remit
- keep inflation at 2% +/- 1%
- maintain financial stability (prevent banks from collapsing)
What is the transmission mechanism?
- the way by which an increase in the Official Bank Rate filters through to the macroeconomy
- the Bank Rate is the interest rate that the BofE charges retail banks for secured overnight lending - at the end of each day, a bank may find itself in debt meaning the BofE will lend it money, using the Bank Rate as the cost of borrowing.
- this shows how the bank rate filters through to retail banks, because retail banks will then alter their interest rates on loans and savings, so that they can pay back the BofE.
What are the three things that interest rates can affect?
- consumer expenditure
- hot money flows (net exports)
- firms investment
Explain how IR changes can affect net exports?
- increase in interest rates - must be relative to other countries
- makes it more attractive for international savers to save their money in the UK
- therefore, this will lead to an increased demand for the £
- draw rightward shift (ER diagram)
- this will result in an appreciation of our currency
- Stronger pound makes exports less attractive, as they will be more expensive. Simultaneously, imports become cheaper relative to domestic goods meaning that the demand for imports increases.
- decreased (X-M)
- inward shift in AD
How does QE cause an increase in the rate of inflation?
1)
- QE is when the Bank of England buys govt and corporate bonds
- in doing so, the demand for bonds increases
- the relationship between the bond’s price and its yield is inversely proportional because if the price of the bond increases, then the coupon, the return on the bond, will be a smaller percentage of the new price, meaning that the yield will be lower
- bond yields act as a benchmark for other interests rates, meaning that they filter out to retail bank rates.
- the lower interest rate means that consumers are incentivised to spend, as the cost of borrowing will be less. People might also take out more mortgages due to lower rates
- boosts AD
- brings inflation up to 2%
2)
- when the Bank buys govt and corporate bonds it is buyng less liquid assets in exchange for liquid money which businesses and the government can use
- this increases the money supply in the economy
- Fischer equation MV=PQ
- assuming that output (Q) and velocity of circulation (V) stay constant, an increase in money supply will also increase the price of the good.
How effective is QE?
1)lack of lending
- although banks have greater reserves of money, QE may be ineffective if banks sit on their balance sheets and reduce their leverage instead of lending to the private sector
- with low interest rates, it is less profitable for banks to lend out money, meaning there is a higher opportunity cost of lending
2) can affect exchange rates
- lower relative interest rate could lead to hot money outflows as the country becomes less attractive for international savers.
3) Clear link between QE and asset price bubbles.
- an asset price bubble is a speculative price bubble in which asset price rises are fuelled by exaggerated expectations for future price rises.
- additional liquidity provided by QE used to buy existing assets, thus pushing up prices, rather than being used for productive capital investment.
what are the four main effects of QE?
- wealth effect - leads to higher share and bond prices
- borrowing cost effect - causes interest rates to go down
- lending effect - sale of less liquid assets in exchange for liquid assets in the form of cash enables firms that have sold bonds to be more liquid, therefore more likely to lend out money
- currency effect - low interest rates can cause hot money outflows, causing a depreciation in currency, meaning that net exports will improve, due to imrpoved competitiveness of exports
Why is the financial sector important?
- 1.08m jobs as of Q1 2022, 3% of all those employed
- gives the govt huge amounts of tax revenue - constituting 10% of all its recepits
- gives surplus in financial account - helps to reduce deficit in net exports - Exports of UK financial services were worth £61.3 billion in 2021 and imports were worth £16.6 billion, so there was a surplus in financial services trade of £44.7 billion.
- in 2021, the financial services sector contributed 173.6bn to the UK economy, 8.3% of all GDP
Why is it important that the BofE regulates the financial sector?
Because it’s prone to market failure
- moral hazard - the risks to society are much greater than the risks to bankers, who are protected in what they do
what are the different ways in which market failure can occur within the financial sector
Moral hazard - exists in a market where an individual or an organisation takes more risks than they should because they know that their actions are covered by insurance, or that the government will protect them from any damage as a result of those risks.
Asymmetric information - this is where one party has much more information than another, and so uses this gap in knowledge to exploit them
Market bubbles - when the price of something is driven well above what it should be, due to the behaviour of consumers
Market rigging - when firms work together and collude to effectively increase their profits by exploiting consumers
Principal agent problem - this is where different actors of the same entity have different interests and ambitions, which can cause a market failure because one, for instance a shareholder, might solely want to maximise profits, whereas the CEO might have other goals
Externalities - market transactions may have negative or positive consequences for third parties
Speculation - risky action in which an individual tries to predict whether the price of an asset will go up, and so buys or sells accordingly to try and make a profit. Some forms of speculation are illegal and have been used at the expense of entire currencies.
Incomplete markets - only a proportion of potential demand is met
what is the sub-prime mortgage crisis? Go through the logical chain of reasoning.
and what is it an example of?
- the Fed Reserve was cutting interest rates in order to boost economic growth, which in turn made it easier for people to qualify for subprime loans, despite having low credit ratings
- home ownership increased massively, not only with less well off people, but with well-off people as well
- with increased demand for housing, and therefore house prices rising, more investors started investing in real estate
- the federal reserve then began to raise interest rates to quell inflation - raised it over a dozen times to 5.25% by 2006.
- the bubble burst, causing prices to plummet back down
- lenders (banks) filed for bankruptcy, or had to offload many workers
- this is an example of how the financial sector is prone to market failure and requires regulation because there was asymmetric information and a moral hazard, two market failures, present in this example. When lenders gave out subprime loans to people with lower credit scores, they would sell this loan to an investment bank, who would then bundle this loan with other prime and subprime loans for other parties to invest in. Crucially, those buying (e.g., pension funds) these mortgage bundles didn’t know that they were subprime and therefore didn’t understand the risk attached to them, as they had been given higher credit ratings than they were due etc. Therefore, as interest rates went up and many were unable to repay their loans, some financial institutions began to accumulate sub-prime debt. The US govt in the end had to bail out banks such as Fannie Mae and Freddie Mac.
- also an example of a moral hazard, because the risks that banks were taking were disproportionately large. Bankers were only concerned with their own profits, and ultimately drove the bubble to burst. The fact that the govt ended up bailing out banks shows how they received protection despite taking excessive risks.
How effective is the Bof E in maintaining financial stability?
Arguments that it is effective:
- the Bank of England supervises 1500 financial services and institutions, including banks, insurers and pension funds, through the PRA, and the FCA (Prudential Regulation Authority and the Financial Conduct Authority)
- they stress test these institutions to understand and ensure that they will be able to cope with future sourer economic conditions, using computer simulations
- a different example - bank buying up 65bn pounds in bonds to save pension funds. - correcting the crisis caused by Kwasi Kwarteng
- bank of england introduced the senior managers regime, which was one of the post-crisis reforms targeted specifically at trying to reduce the market failure of moral hazard, by making sure that managers and leaders of regimes are accountable for the firm’s failures as well as successes. have to submit a responsibilities map to show the hierarchy and responsibilities within the firm.
Arguments that it isn’t effective:
- Bank’s monetary policy can be damaging for financial stability - by trying to maintain price stability they may fail to keep financial stability
- e.g., rising interest rates and the collapse of SVB
- Fed’s reaction to this has also been to pay depositors who lost money, and enable other banks which might potentially be vulnerable to the same thing to sell their bonds at their face value rather than their current, lower market value.
- encourages future reckless behaviour from banks, as bankers won’t need to discriminate between good risk and bad risk if the bank is willing to protect banks from the effects of an interest rate rise.
How can raising interest rates cause damage to the financial sector? (evaluation of interest rates or can be used as a point for why banks are prone to market failure)
- during the pandemic, there was a boom in demand for gadgets and digital services
- therefore, tech companies were increasingly drawing on deposits that they had made to SVB in order to satisfy increased demand for tech goods
- therefore, it began to invest in long-dated government bonds, Treasuries, assets with reliable returns.
- however, with changing economic conditions, and tech companies suffering, many of SVB’s customers were withdrawing money, but SVB didnt have enough cash to hand
- at the same time, with the Fed raising interest rates dramatically, SVB’s portfolio had taken a huge hit, because bond price and yield are inversely proportional
- SVB was forced to sell its assets at huge losses to create the cash for those withdrawing money
- when it released its balance sheet, this spooked investors, fuelling a bank run
- this demonstrates the unexpected consequences of some of the bank’s objectives - by attempting to keep inflation low, it failed to maintain financial stability
For the future:
- European banks look more secure - bank run was fuelled by flighty tech companies ready tow quickly withdraw deposits
- Federal Reserve has already had agreed for banks to sell Treasuries back to the Fed at their face value rather than their current market value. This shows how the Fed is acting to try and prevent banks from collapsing, by providing emergency support to banks, preventing another bank run. However, by creating the expectation that the central bank will assume interest-rate risks in a crisis, it is encouraging banks to behave recklessly.
- regulators need to stress-test banks to ensure that their safety buffers are large enough to withstand economic changes
How can the example of Japan’s economic situation be used as evidence for evaluating central banks’ monetary policy
- Japan - Japan has experienced decades of low economic growth, low inflation if not deflation, and some negative interest rates to incentivise spending.
- consequently, this has meant that with low yields, Japanese banks have been drawn to long-term bonds to get higher returns.
- but with inflation rising across the world, and consumer-price inflation at 4.3% in January 2023, the central bank (BOJ) might have to increase interest rates
- a 1 percentage point rate rise would knock more than 9trn yen off the banks’ yen-denominated bonds
- consequently, this crucially shows what is at stake when a central bank increases interest rates to try to reduce inflation.
summarise the different examples of market failure in the financial sector
Subprime mortgage crisis
- when banks sold their subprime loans to investment banks, so that they could use this money to give out more loans, investment banks bundled these mortgages with subprime and prime loans, making them appear to have higher credit ratings than they did. As other parties invested in these bundles, they didnt know that they were buying sub-prime debt, which by this point couldnt be paid back, because interest rates were too high
- example of moral hazard, asymmetric information
Libor Scandal
- British banks, such as Barclays, RBS, HSBC, were found to be under-reporting their inter-bank rate to Reuters. By under-reporting their rate, they believed that they would make their banks look stronger, because a low interest rate would indicate that they were creditworthy, thus boosting profits
- this is an example of market rigging, because banks were colluding with each other in order to make more profit
Enron Scandal
- Enron, an energy firm, shifted huge amounts of debt into shell companies so that the debt wouldn’t be disclosed in their statements, and included expectations about future profits in their accounts. Effectively, the company hid huge amounts of debt and tried to make it look more profitable than it was
- asymmetric information - exploiting and lying to shareholders and consumers
Wall Street Flash Crash 2010
- speculation
- HFT used computerised trading programs to create large sell orders, causing the price of those shares to fall, and then pull out of the sale at the very last second in order to benefit from buying shares at a lower price
- wiped $1trn temporarily off the value of shares on the NYSE
