Monetary Policy

Question 1

Purpose of Monetary Policy

Answer 1

Controlling the Money Supply
Manipulating levels of AD
Govt. Objective = Price Stability
Controlling inflation
Promote Economic Growth
Reducing Unemployment

Question 2

Monetary Policy Committe (MPC)

Answer 2

Part of the BoE
Set interest rates (Bank Rate)
Aim to achieve the Govt. objective of 2% inflation (+/- 1%).
Aid Macroeconomic stability

Question 3

Monetary Policy tools

Answer 3

Interest Rates
Quantiative Easing
Economic Data: House Prices, size of output gaps, exchange rate + Income data.

Question 4

What causes the MPC to change the Base Rate ?

Answer 4

High Unemployment rate
Low Savings rate
High Consumer spending
High commodity prices
Weak Exchange rate (WPIDEC)

Question 5

Likely impacts of increasing interest rates

Answer 5

Less borrowing / Investment
Less Consumption
Increased Savings
Reduced confidence
Decrease in exports
Increase in imports

Question 6

Impact of increased IR on Exchange Rate

Answer 6

Increase IR leads to increased demand for the £
Demand rises as foreign investors want to capitalise on the high interest rates of British savings
Increased demand for the £ leads to an increase in the value of the £ - Appreciation.

SPICED - Worsening Current Account

Question 7

Impact of falling IR on ER

Answer 7

Falling IR leads to falling demand for the £
Demand falls as the reward from saving falls
The falling demand leads to falling value of the £ -depreciation.

WPIDEC - Improving current account

Question 8

Transmission Mechanism - Reduced IR

Answer 8

MPC reduced the Bank Rate
Interest rates on mortgages/ loans falls (Market rates)
Increased House / Asset prices - demand pull
Growing Confidence
The exchange rate will fall - WPIDEC
Increases in both external and domestic demand
Domestic Prices rise (Demand-pull)
Price of imports rises
Overall inflation

Question 9

Transmission Mechanism - Increased IR

Answer 9

MPC increase the Base Ranks
Interest rates on mortgages / loans increase (market rates)
Falling House/Asset prices - lower (domestic) demand / increased savings incentive
Falling confidence
Rising exchange rate - SPICED
Fall in British Export demand (external)
Falling inflation due to lower total demand.

Question 10

Contractionary MP - Aims / Tools

Answer 10

Reduce levels of aggregate demand in the economy
Increasing interest rates
Restricting the Money supply
Strong Exchange Rate.

Question 11

Expansionary MP - Aims / Tools

Answer 11

Increase levels of AD in the economy
Quanititative Easing
Low interest rates
Few restrictions on the money supply
Weak ER

Question 12

Evaluation of MP

Answer 12

Spare Capacity
Inflation
Confidence levels
Size of intervention
Time lag
Willingness of banks to pass on base rate

Question 13

Quantitative Easing (QE)

Answer 13

Creating money (digitally) and purchases financial assets (usually gilt bonds).
Demand-pull inflation for gilt bonds - bond yield decreases.
The incentive to save with banks increases and the banks have more liquid funds.

Therefore, the demand for mortgages, loans and other investments increases.

Commercial interest rates fall and the marginal propensity to consume increases, leading to a rise in AD.

This can be exacerbated by the accelerator and multiplier effects.

GDP and Inflation may rise depending upon the trade cycle position.