Monetary Policy Flashcards
Who controls the monetary policy?
The Central Bank of England
What is the monetary policy ?
Type of demand-side economic policy. Monetary policy is when the central Bank of England manipulates the base of interest rate or the money supply in order to influence aggregate demand in an economy
Define base interest rate
The interest rate that the central bank of England set when lending money to high street banks
If the base interest rate goes up..
High street banks interest rates will also go up . Vice versa
If the inflation rate is above the target, what will the Bank of England pursue
The Bank of England will pursue contractionary monetary policy by increasing the base interest rate so high street banks will also increase their interest rates so consumers will receive a higher return on savings so they’ll choose to save more and spend less, decreasing consumption which will decrease aggregate demand shifting inwards from AD to AD1 which decreases the price level which reduces inflation , which as a result will pull inflation back into its target range
If the inflation rate is below the target, what will the Bank of England pursue
The Bank of England will pursue expansionary monetary policy by decreasing the base interest rate so high street banks will also decrease their interest rates so consumers will receive a lower return on savings so they’ll choose to save less and spend more, increasing consumption which will increase aggregate demand shifting AD to AD1 which increases the price level creating demand pull inflation , which as a result will pull inflation back into its target range
Define recession
Two consecutive quarters of negative economic growth (quarter =3 months)
Define marginal propensity to consume and how pursuing the expansionary monetary policy will affect it
Marginal propensity to consume is the proportion of additional income that is spent.
A reduction in the base interest rate means consumers will choose to reduce their saving and increase their spending. So, marginal propensity to consume will increase.
vise versa with contractionary
Higher base interest rate due to contractionary monetary policy to decrease inflation rate affect on pensioners
May increase consumption for pensioners as they are receiving higher returns on their savings which would increase their marginal propensity to consume. However, an increase in consumption will shift AD outwards which may lead to demand-pull inflation which is the opposite outcome wanted from the Central Bank of England’s intervention
opposite for consumers
Lower base interest rate due to expansionary monetary policy to increase inflation rate affect on pensioners
May decrease consumption for pensioners as they are receiving lower returns on their savings which would decrease their marginal propensity to consume. However, a decrease in consumption will shift AD inwards which may lead to deflation which is the opposite outcome wanted from the Central Bank of England’s intervention
opposite for consumers
Explain the impact of a lower interest rate for mortgages on aggregate demand
A reduction in the interest rate makes mortgages more affordable, because less interest has to repaid on a mortgage. Cheaper mortgages enable more consumers to buy houses, which will increase the demand for houses. This will increase the price of houses and leads to the positive wealth effect. The positive wealth effect is where people increase their consumption as a result of an increase in the value of their assets. Consumption is 65% of AD so an increase in consumption will increase aggregate demand causing economic growth
However, Richard Sousa has shown that the positive wealth effect is non-existent in many European countries. This is because a lot of people do not own their own houses and are saving up for a house. As a result, an increase in house prices will actually make them feel poorer and force them to save even more. This will reduce consumption. Consumption is 65% of AD so a decrease in consumption will decrease aggregate demand causing negative economic growth
Explain the impact of a higher base interest rate for mortgages on aggregate demand
An increase in the base interest rate makes mortgages less affordable, which will decrease the demand for houses. This will decrease the price of houses, leading to the negative wealth effect. The negative wealth effect is where people decrease their consumption as a result of a decrease in the value of their assets. This will decrease aggregate demand.
However, Richard Sousa has shown that the negative wealth effect is non-existent in many European countries. This is because a lot of people do not own their own houses, and so a decrease in house prices will actually make them feel richer. This will increase consumption and aggregate demand.
Explain the likely impact of a decrease in the base interest rate of investment
A decrease in the interest rate means that borrowing is cheaper and so investment is likely to increase. This will shift AD out, because investment is a component of AD. Investment will also increase the productivity of the factors of production, which will shift the LRAS out. Both of these will increase real GDP and lead to economic growth.
However, if aggregate demand and animal spirits are particularly low, firms might be concerned that investment will be wasted. This could mean that they do not make a profit on the investment, leaving them unable to pay it back and therefore in debt. So, a decrease in the interest rate might not actually increase investment and economic growth.
Explain the likely impact of a increase in the base interest rate on investment
An increase in the interest rate means that borrowing is more expensive and so investment is likely to decrease. This will shift AD in because investment is a component of AD. Investment will also decrease the productivity of the factors of production, which will shift the LRAS in. Both of these will decrease real GDP and lead to a reduction in economic growth.
However, an increase in loan repayments will increase costs for firms. This will shift SRAS in and force firms to increase their prices. This will increase inflation, which goes against the aims of contractionary monetary policy.
Why can’t interest rates go below 0 and what is the lowest it can go?
Interest rates can’t go below 0 because it would be negative and if you were to put money in the bank, you would get less back than you put in.
The lowest interest rates can go is 0 which is called the zero lower bound
When the base interest rate gets close to the zero lower bound, the central bank of England can’t drop the base interest rate any lower so the bank pursues a more extreme monetary tool called quantitative easing
