Monetary Policy Flashcards
Monetary Policy
The use of interest rates, money supplied and exchange rates to influence the macroeconomic objectives and control inflation
The role of commercial banks
- take deposits from customers and turn them into assets
- then lend deposits at a higher rate with added interest
- the rate of IR is influenced by the base rate of the central bank as commercial banks deposit and borrow money from them
Symmetric inflation targeting
A target requiring actions if inflation falls below or above target
Assymetric Inflation Targetting
A target requiring actions if inflation only rises above target
Expansionary Monetary Policy
- decrease interest rates to increase AD
- increases economic growth
- unemployment decreases
- but inflation increases too
1. Consumption
- cost of borrowing decreases, people stop saving and instead borrow money
- start to spend more, consumption increases as more RDY
- AD increases and shifts
2. Investments
- cost for borrowing decreases, firms more incentivised to take out money and invest
- also more confident as consumption increases AD increases
- can lead to non inflationary growth as invest in capital so productive capacity increases and so LRAS increases aswell
Contractionary Monetary Policy
- increase interest rates to decrease AD
- decreases economic growth
- unemployment increases
- inflation decreases
1. Consumption
- cost of borrowing increases, people start saving instead
- start to spend less, consumption decreases as less RDY
- AD decreases and shifts
2. Investments
- cost for borrowing increases, firms less incentivised to take out money and invest
- also less confident as consumption decreases AD decreases
Why does it take time for changes in the Central Bank base rate to filter through the economy?
When the Central Bank lowers base rates commercial banks borrow from the central banks and lower interest rates to pass onto the consumers which takes time
Why were individuals and firms still not confident even if IR was low?
Because banks were not passing on low interest rates to consumers and firms because they lacked confidence and trust
- banks wanted to increase their liquidity so kept a lot of deposits
Liquidity trap
A situation in an economy were interest rates cannot fall any lower and monetary policy cannot impact aggregate demand
Money Supply
The quantity of money that is in circulation in the economy
Quantitive Easing
When the central bank buys bonds to lower interest rates on savings and loans
- increasing the money supply of economy
Channels of QE
- The central bank creates electronic money so there’s more money in the UK
- The central bank predominantly are going to buy government bonds to try decrease the yield of government bonds because investors think it is a safe place to invest when have no confidence
- They want to de-incentivize people from buying government bonds - This leads to people looking for the second less riskiest bond to invest in which is corporate bonds
- The central bank then also buy corporate bonds to decrease the yield of corporate bonds
- This causes people to start saving in financial institutions with increases liquidity
- People are now more confident as went before so may borrow more to spend
- Banks are now more incentivized to give out loans at lower interest rates so people borrow more and spend which increases AD so can leave recession (multiplier effect)
- Because financial institutions don’t want lower yield so they will buy shares or firms and so share prices increases so firms have wealth effect so invest more which increases AD
- Furthermore, cheaper for firms to borrow when yield decrease through bonds so firms give out more bonds which increases investments which increases AD
Advantages of QE
1. Useful when conventional monetary Policy fails
- helps get the economy out of a liquidity trap
- if no QE the economy would be in a constant recession and persistent deflation
2. Cuts commercial interest rates
- makes it easier for firms to borrow money and chesper mortgages
3. Increases confidence
- increases consumer and firms confidence
- consumers more likely to borrow and spend more causing firms to become more confident and invest
- stimulates economic growth and helps economy get out of a recession
Disadvantages of QE
1. Inflation
- as increasing the supply of money, so consumption increases which increases inflation
2. Difficult to reverse QE/recession
- can eventually lead to a recession as taking more money out of the economy
3. Time lag
- the transition mechanism will take a long time to actually see the impacts of quantitative easing
- won’t immediately take the economy out of a recession and show impacts
4. Borrowing more money
- trying to solve adept crisis through more borrowing which may not always be successful
- further worsens the national debt of the economy
5. Banks may sit on their liquidity so may still not give out loans
6. Increases income and wealth inequality
- firms and high income households are more likely to afford loans and by expensive goods
- so demand increases for these expensive goods which means house and share prices increases which increases the value of the assets
- harms low income households as demand increases, prices also increase so less affordable
7. Pension funds are negatively impacted
- invest a lot of money into government bonds and corporate bonds
- yield will decrease which decreases the amount of money in pension funds so over time money increases slower in pensions
8. IR decreases, hot money outflows
- bad for savers as the reward for saving decreases
- could lead to hot money outflows as people from abroad start to take their money out and save their money in other countries
- decreases the money supply for banks and so have less liquidity
9. Small firms wont benefit as much
- the government isn’t buying small firms shares or bonds so they aren’t gaining more money
- banks may still not give loans to small firms as may see still see them as risky
10. Lower confidence
- a sign that the economy is not doing well so firms become reluctant to invest and consumers stop consuming
Advantages of Monetary Policy
1. Changes in IR
- consumption increases
- crowding in as firms also borrow more to fund investments
- government find it cheaper to borrow so they also increase government spending
- positive multiplier effect
2. Monetary policy powerfully impacts AD
- Directly impacts consumption and Investments as it is impacting your cost of borrowing and reward for saving
- UK is a nation of homeowners so quite useful and successful, when IR goes down pay less mortgages
- more RDY so consumption increases
3. potential to shift both LRAS and AD simultaeuously
- increase in investment which improves the productive capacity of the economy, shifting LRAS
- Investments is also a component of AD so AD also shifts
- non-inflationary growth as there is enough capital to meet increasing demand so price level stay stable
4. Bank of England is an independant body
- free from any political manipulation
- main objective is to prevent inflation even if it means decreasing economic growth
- government cannot interfere
