Monetary policy Flashcards
Role of the Bank of England
- Implementation of monetary policy
- Banker to the government – central banks perform various banking services such as handling accounts of government departments and making short term advances to the government.
- Banker to the banks – lender of last resort – if banks run into liquidity problems they may be able to borrow direct from the central bank.
- Role in regulation of the banking industry, one example is that the central bank may increase the reserve requirements that the banks need to have at the central bank and therefore reduce the amount of money in circulation.
Role of the central banks - Lender of last resort
- Crucial for a firms financial stability.
- Banks borrow short-term but lend long-term, they can sometimes face a shortage of liquidity.
- If an individual bank thats solvent faces a temporary shortage of liquidity, the central bank can provide this by lending them money.
- The central bank can also charge higher rates of interest for emergency funds in order to creat a incentive to act more carefully in the future.
Advantages and Disadvantages of being ‘A lender of last resort’
Advantages
- Prevents panic and a run on the banks
- Helps ensure financial stabilitiy
Disadvantages
- Can lead to moral hazard and for banks to take excessive risks.
- Lead to banks not holding sufficient liquidity
What is Liquidity
- Financial instruments such as coins, notes, shares and bonds can count as money and therefore part of the money supply.
- Liquidity refers to how easily something can be spent, coins and notes are very liquid and can be spent easily, but shares must be converted into cash first and therefore are less liquid.
- Banks need to have a certain amount of liquid assets available, they lend over long periods of time, but depositers epxect to withdraw savings immediately.
- If too many debtors want to withdraw their money at the same time some banks may not possess the liquidity to do so, however if people though such savings were at risk this could happen.
THIS IS WHY the central bank must act as a lender of last resort.
The central banks function - Banker to the government
- A central bank can help the government manage its national debt, for example by trying to reduce the interest paid, this migh involve issuing government bonds.
- It can also advice the government on economic matters.
Purpose of the MPC
- Controling the money supply, through interest rates and quantattive easing they can…
- Control inflation
- Reduce economic growth and unemployment
ALTHOUGH there is a trade off
CPI inflation target 2% +/- 1%
Increase in interest rates on (X-M)
An increase in interest rates in the UK will make it more attractive for foreigners to put their money on deposit here. But foreigners cannot put their foreign currency into our UK banks, so there will be an increase in international demand for pounds. The increase in demand for £ will increase the international price of £,
Appreciation will mean that exports are more expensive and therefore will fall and inports are cheaper and will rise.
X-M falls
EVAL Monetary policy
- Even if the cost of borrowing is low, consumers might be unable to borrow because banks are unwilling to lend. After the 2008 financial crisis, banks became more risk averse.
- Interest rates will be more effective at stimulating spending and investment when consumer and firm confidence is high. If consumers think the economy is still risky, they are less likely to spend, even if interest rates are low. Banks may also not be willing to lend.
- The strength of monetary policy (and other demand side policies such as fiscal policy) depends upon the magnitude of the multiplier. The Multiplier effect refers to the increase in final income arising from any new injection of spending.
- The elasticity of the AS curve will determine the effectiveness of monetary policy.
- Conflicts of objective may occur e.g. when interest rates are raised to reduce inflation, the AD curve shifts left and negative economic growth and unemployment result.
- Monetary policy is generally regarded as having a shorter time lag than fiscal policy. It takes around 18-24 months (UK) for the full impact of a change in interest rates to be felt by the economy.
- The growth of fixed interest rate mortgages, which are unaffected by changes in interest rates, reduces the effectiveness of changes in interest rates on consumer spending C.
Consumer is the largest component of AD in the UK, it’s around 70 percent of AD. A loss on the C side can seriously impact AD. - Fiscal policy can target specific areas, depending on where the government spends and who they tax.
- Monetary policy can worsen income distribution, wealthier people will save more and poorer people will borrow more, interest rates increases mean dispraoportionate results.
Liquidity Trap
When monetary policy becomes ineffective because, despite zero/very low-interest rates, people want to hold cash rather than spend or buy illiquid assets.
- Very low interest rates, low inflation and slow or negative growht. People have a preference to spending rather than growth, monetary policy becomes ineffecive in boosting demand.
Because of expectations of future interest rates movements, low interest rates mean people think there is something wrong with the economy.
How to overcome a liquidity trap effect?
- In a liquidity trap, fiscal policy may become more important as an instrument of demand-management e.g. running a larger budget deficit to boost demand and increase the money supply.
- There is also pressure on central banks to supply the financial markets with extra liquidity to encourage them to lend to each other again and increase the flow of funds available for borrowers
- A rise in inflation can also help! Because higher inflation can lead to real interest rates being negative and eventually stimulating an expansion of household and corporate spending.
- The central bank may want to establish in people’s minds that they will keep real interest rates low as a way of altering expectations.
How do interest rates effect the exchange rate?
- When interest rates are high in the UK, people are more likely to buy the pound, there is high reward for saving at high interest rates.
- Increased demand for the pound results in a appreciation.
Why would QE be neccessary?
- Low buisness confidence.
- Very low willingness of the bank to lend.
QE
QE is neccessary to adopt ‘loose’ monetary policy in order to stimulate aggregate demand, at a time when interests rates are already very low.
- It increases the money supply.
- It involves the Bank of England ‘creating new money’ electronically, this is similiar to printing new money and using it to buy govt bonds and assests owned by financial insitutions and other firms, the hope that they will spend the money or lend it to others.
Added benefit that a fall in interest rates means a depreciation, this has no such change.
HOWEVER financial insitutions can use this money to increase their reserves and only lend it out when the economy improves.
Evaluating QE
- Inequality as it benefits the richest first as it boosts asset prives.
- Conversely, there is a risk that QE could unleash a bout of inflation due to AD shifting right too much.
- Another danger of using QE is that financial institutions may initially use this ‘new money’ to increase their reserves, and only lend it out when the economy improves. Meaning there could be extra lending in times where it isnt needed.
- Hard to quantify the effect of QE
Quantative tightening
It involves selling government bonds to banks or the central bank letting bonds mature and then removing them from their balance sheet.
When the central bank buy bonds from banks, this reduces liquidity, or money, from financial markets & might then limit the value of bank lending.
If the central bank is no longer acting as a purchaser of new issues of bonds, this fall in demand might cause bond prices to drop.
As a result, the yields on government bonds will move higher. Consequently, other market interest rates might rise too.
