Monetary Policy

Question 1

Monetary Stability

Answer 1

Means stable price and confidence in the currency

Question 2

Stable prices

Answer 2

Are defined by inflation of 2% which the banks seek to meet via decisions

Question 3

Monetary policy

Answer 3

Involves changes in:

Money supply
IR
X change rate

to influence the economy

Question 4

Ways in which increases in IR decreases AD (3)

Answer 4

• Household consumption falls
• High IR reduces business investment
• Inflows of hot money result in appreciation of the pound (SPICED and WPIDEC)

Question 5

Hot flows

Answer 5

Firms and individuals looking to get the highest rates of return, flows into the UK. Usually when interest rates are higher than other nations

Question 6

Fall IR: Foreign investors

Answer 6

• UK banks become less attractive
• Investors sell their pounds
• Supply for the pound increases
• The pound depreciates

Question 7

High IR: Investors

Answer 7

• UK banks become more attractive
• Investors buy their pounds
• Demand for the pound increases
• The pound appreciates

Question 8

Expansionary (loose) monetary policy (3)

Answer 8

• Fall in nominal IR
• Measures to expand the supply of credit from the banking system
• Depreciation of the external value of the exchange rate

Question 9

Deflationary (tight) monetary policy (3)

Answer 9

• High IR: loans and savings
• Tightening of credit supply
• Appreciation of the exchange rate

Question 10

Cut in IR: Inflation affects

Answer 10

• C+I+X increases, M decrease
• Shifting AD right and pushing up the price level
• This is an example of loose monetary policy

Question 11

Why a small building businesses would like low IR (2)

Answer 11

• Mortgages cost less: more demand for housing
• Loans are cheaper

Question 12

Why the government may be worried about deflation (3)

Answer 12

• Consumers delay spending waiting for a cheaper price
• Firms see low revenues this could lead to job losses
• Job losses mean less tax revenue and more benefit spending for the given

Question 13

Why the BOE cut IR during a downtown:recession (6)

Answer 13

• Lower costs of loans
• ⬆️ Confidence therefore spending
• ⬆️ Disposable incomes
• ⬆️ Business investment
• ⬆️ House demand therefore house prices
• WPIDEC: weak currency will ⬆️ exports

Question 14

Why Low IR may not be effective (4)

Answer 14

• Low animal spirits
• Savers suffer: real incomes falls
• Deflation: causing real IR to rise
• Fiscal policy in opposite direction: austerity

Question 15

Keynesian liquidity trap

Answer 15

Occurs when low IR and high cash balance in the economy fail to stimulate AD

Question 16

Keynesian liquidity trap explained

Answer 16

• In normal circumstances it’s possible to boost demand by cutting IR
• Most countries have a zero floor for nominal IR
• If the IR is lowered there will be little effect if people cannot or will not borrow, this is know as the liquidity trap

Question 17

Purpose of negative IR (3)

Answer 17

• Get banks lending money
• Bring a reduction in real IR
• Depreciate the exchange rate

Question 18

What does Monetary policy involve?

Answer 18

Money supply
Interest rates
X-Change rates

Question 19

Steps of quantitive easing (5)

Answer 19

1. BOE electronically creates money
2. BOE buys gov bonds from financial firms
   3a. Financial firms invest these funds and lend more out
   3b. Increase in price of bonds (more are brought) reducing the yeild
   4b. This lowers the IR throughout the financial sector
3. Boosts AD

Question 20

What is a bond?

Answer 20

Is an IOU

Question 21

BOE inflation target

Answer 21

2% but is symmetrical by 1% meaning that 1% to 3% is acceptable

Question 22

What is the transmission mechanism

Answer 22

How a change in the base rate by the BOE affects the price level (inflation)

Question 23

How long does the transmission mechanism take?

Answer 23

24 months

Question 24

Expansionary monetary policy

Answer 24

Used during a recession to boost AD, it involves increasing the money supply and decreasing the IR and the exchange rate

Question 25

Contractionary monetary policy

Answer 25

Used during a doom to decrease AD, involves decreasing the money supply and increasing the IR and the exchange rate

Question 26

What are bonds?

Answer 26

IOUs there are corporate and government bonds

Question 27

What was forward guidance?

Answer 27

• BOE said they won’t increase IR if UE remains above 7%
• This builds confidence and helps with planning for businesses