Monetary Policy Flashcards
Monetary Stability
Means stable price and confidence in the currency
Stable prices
Are defined by inflation of 2% which the banks seek to meet via decisions
Monetary policy
Involves changes in:
Money supply
IR
X change rate
to influence the economy
Ways in which increases in IR decreases AD (3)
• Household consumption falls
• High IR reduces business investment
• Inflows of hot money result in appreciation of the pound (SPICED and WPIDEC)
Hot flows
Firms and individuals looking to get the highest rates of return, flows into the UK. Usually when interest rates are higher than other nations
Fall IR: Foreign investors
• UK banks become less attractive
• Investors sell their pounds
• Supply for the pound increases
• The pound depreciates
High IR: Investors
• UK banks become more attractive
• Investors buy their pounds
• Demand for the pound increases
• The pound appreciates
Expansionary (loose) monetary policy (3)
• Fall in nominal IR
• Measures to expand the supply of credit from the banking system
• Depreciation of the external value of the exchange rate
Deflationary (tight) monetary policy (3)
• High IR: loans and savings
• Tightening of credit supply
• Appreciation of the exchange rate
Cut in IR: Inflation affects
• C+I+X increases, M decrease
• Shifting AD right and pushing up the price level
• This is an example of loose monetary policy
Why a small building businesses would like low IR (2)
• Mortgages cost less: more demand for housing
• Loans are cheaper
Why the government may be worried about deflation (3)
• 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
Why the BOE cut IR during a downtown:recession (6)
• Lower costs of loans
• ⬆️ Confidence therefore spending
• ⬆️ Disposable incomes
• ⬆️ Business investment
• ⬆️ House demand therefore house prices
• WPIDEC: weak currency will ⬆️ exports
Why Low IR may not be effective (4)
• Low animal spirits
• Savers suffer: real incomes falls
• Deflation: causing real IR to rise
• Fiscal policy in opposite direction: austerity
Keynesian liquidity trap
Occurs when low IR and high cash balance in the economy fail to stimulate AD
Keynesian liquidity trap explained
• 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
Purpose of negative IR (3)
• Get banks lending money
• Bring a reduction in real IR
• Depreciate the exchange rate
What does Monetary policy involve?
Money supply
Interest rates
X-Change rates
Steps of quantitive easing (5)
- BOE electronically creates money
- 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 - Boosts AD
What is a bond?
Is an IOU
BOE inflation target
2% but is symmetrical by 1% meaning that 1% to 3% is acceptable
What is the transmission mechanism
How a change in the base rate by the BOE affects the price level (inflation)
How long does the transmission mechanism take?
24 months
Expansionary monetary policy
Used during a recession to boost AD, it involves increasing the money supply and decreasing the IR and the exchange rate
Contractionary monetary policy
Used during a doom to decrease AD, involves decreasing the money supply and increasing the IR and the exchange rate
What are bonds?
IOUs there are corporate and government bonds
What was forward guidance?
• BOE said they won’t increase IR if UE remains above 7%
• This builds confidence and helps with planning for businesses
