Monetary Policy

Question 1

2 tools of monetary policy

Answer 1

Money supply
Interest

Question 2

Core purposes of BoE (2)

Answer 2

Financial stability (lender of last resort)
Monetary stability (stable prices and confidence in currency)

(Their independence is in question following brexit decisions)

Question 3

UK post war monetary policy regimes

Answer 3

Regime 1 - fixed exchange rates
Regime 2 - floating exchange rates, no monetary anchor
Regime 3 - money targets
Regime 4 - ERM (exchange rate targeting)
Regime 5 - inflation targeting (finally inflation around 2%)
Regime 6 - inflation targeting (now with independent CB)

Question 4

Why make CB independent

Answer 4

Prevent political manipulation e.g prior election

Question 5

How can political manipulation occur

Answer 5

Recall fiscal policy equation.

Monetary expansion (increasing M) is tempting (to improve fiscal balance rather than increasing taxes and aggravating households) but has a consequence - inflation.

So, central bank independence avoids “inflation bias“. If not independent, gov would just increase money supply rather than taxes to seem favourable to voters who wont have to pay tax (note: under Neoclassical Ricardian equivalence suggests people do understand this (if government borrow rather than increase money supply) and thus do not respond to stimulus and so do not create a multiplier effect!)

Question 6

So avoiding political manipulation is one reason we make CB independent.

Problems still with central bank (2)

Answer 6

Democratic oversight - chancellor sets the target, and chooses external MPC members. (So is it really independent?)

Also letters to chancellor if below/above target

Question 7

Central bankers will still not be insulated from all short and long term political pressures.

The public will understand this, so still have inflation expectations and limit multiplier effect.

Potential solutions to inflation bias (2)

Answer 7

Appoint conservative central bankers who are known to be tough on inflation.

Remove discretion, use monetary rules e.g Friedman rule. (Commitment device to anchor expectations)

Question 8

Supply shock inflation/output dilemma pg 14

Answer 8

A>B is negative output gap. Higher inflation too.
Dilemma: output/inflation tradeoff

Either increase interest rates, reduces AD and reduces inflation, however in a worse recession.

Or lower interest rates, increasing AD will restore output but will increase inflation further.

Question 9

So they either lower interest rates to restore output but this increases inflation further. Or higher rates lower inflation but worsens output gap (recession)

How will/should the CB respond to these supply shocks

Answer 9

Depends on their loss function (preferences)

Whether they want to prioritise inflation or output.

Question 10

What is the BoE’s preference?

Answer 10

Prioritise inflation (neoclassical)

(leave output/employment to Keynesian:fiscal policy)

Question 11

What is a strict inflation targeting regime

Answer 11

Leave output to fiscal policy. Focus on inflation tackling. (So in that example they would chose to increase interest rates, despite the fall in output, which they leave for fiscal policy to handle.

Question 12

Flexible inflation targeting

Answer 12

It recognises this inflation-output trade-off.

So allows for a balanced approach to other objectives, while retaining price stability

Question 13

Monetary transmission mechanism pg 18

Answer 13

Official rate (base rate) then impacts:

Market rates
Asset prices
Expectations/confidence
Exchange rate (impacts import prices impacting inflation)

They then impact domestic demand and net external demand. TOGETHER=total demand, determining inflation.

Question 14

How to express Money demand instability

Answer 14

(M/P) = L (i,Y) +ε
(Money demand is a function of income (pos rel) and interest (neg rel))

ε = error term to account for the instability.

Question 15

Nominal interest rate under money targeting/control evaluation

Answer 15

Under money targeting it means changes in money demand cause too much variability in the interest rate

(hence why we changed to inflation targeting)

Question 16

Nominal interest rate under interest rate targeting/control

Answer 16

Interest stable.

Question 17

Interest rate rules: Taylors equation

Answer 17

𝑖t=𝜋t+𝜌+𝜃𝜋 (πt−𝜋*t) +𝜃Y(𝑌t−𝑌bart)

𝜋∗t is inflation target
Ybart is natural output
P is natural rate of interest
𝜃𝜋 - parameter representing responsiveness of nominal interest rate to inflation (if high care about inflation)
𝜃𝑌 - parameter representing responsiveness of nominal interest rate to output (if high care about output

Question 18

Stabilising vs destabilising monetary policy: consider an increase in inflation.

Answer 18

Stabilising - Central bank should raise nominal rates more than inflation to influence the real interest rate (OVERREACTION) øπ>0

Higher rates will then lower AD and stabilise inflation.

Destabilising means raising nominal rates less than inflation (underreact) lowering real interest rates. Which increase AD, and worsen inflation further.
-1<Ø<0

Question 19

How successful was the post 1992 monetary policy regimes

Answer 19

Successful 1972-1992. Cut inflation hugely with no sacrifice in growth (recall sacrifice ratio)

Hence why called free lunch and NICE/Great moderation (since inflation fell without losing growth)

But 2007-2012, not successful , we saw negative growth and higher inflation

Question 20

Monetary policy successfulness in keeping inflation target overtime

Answer 20

Since financial crisis 2007, monetary policy has been unsuccessful in maintaining target inflation of 2%.

(2007 onwards to 2012 a lot of letters sent to chancellor i.e not achieving target!)

Question 21

So things went bad. How did they respond?

Answer 21

Rates went low as 0.5%. Believed in a zero lower bound - (Which meant bank will pay you interest to borrow).

So, they switched from conventional to unconventional monetary policy.

Question 22

3 unconventional monetary policies

Answer 22

Large scale asset purchases (quantitative easing)

Expanding central bank credit availability for financial sector (‘funding for lending’ i.e keep circulating money!!)

Forward guidance - pledge to keep policy rate low

Question 23

Back to Taylor’s rule:

If øπ small and øY is large, what does this mean for the DAD curve, and the impact on inflation and unemployment following a supply shock?

Answer 23

DAD curve is steep.

From this, a supply shock will lead to a larger effect to inflation than output. (So they care more about output than inflation)

Question 24

How does quantitative easing work

Answer 24

Prints money, purchases government bonds FROM FINANCIAL INSTITUTIONS (cannot buy directly from gov)

So while demand for bonds rise, bond prices increase, and so bonds become less attractive to the financial institutions (price yield relationship so they earn returns elsewhere by just selling the bonds and lending more. (So basically QE drives banks away from gov bonds, sell them to CB for money and use this to increase lending, which will increase inflation to meet target

Question 25

Assessing the impact of the initial QE in 2009 of £200bn and the subsequent rollouts

Answer 25

Increased GDP by 1.5-2% and inflation by 0.75-1.5%

So successful. However unsure about the success of the following rollouts of QE.

Question 26

2nd unconventional measure: Funding for Lending 2012

What was it, and then what changed in 2013 and why?

Answer 26

Incentives for FI lending to stimulate economy. E.g money given to them.

In 2013: household lending no longer included since was not necessary; Help to buy scheme existed, so focused on lending for businesses

Question 27

Impact of funding for lending scheme (2)

Answer 27

Improved mortgage access (so successful as lended more)

For business lending less clear

Question 28

3rd unconventional measure - forward guidance in 2013

What was their plea?

Answer 28

To install confidence and get agents to borrow/spending to stimulate economy and inflation, MPC pled…

Not raise rate from current 0.5% until unemployment rate falls to 7%.

Question 29

They made caveats to this plea:

They may adjust rates change if (3)

Answer 29

If becomes more likely CPI in 18-24 months will be 2.5%> (so above the 2%, so want to increase rates to lower bring it back down)

Medium-term expectations no longer backed.

Financial stability is jeopardised

(And of course if unemployment reaches 7% as mentioned!)

Question 30

Why do they announce a threshold

Answer 30

To manage expectations (Neoclassical!)

Question 31

What was the problems they encountered in reality, following the forward guidance 2013

Answer 31

Adjust when unemployment fell to 7%. Which they had predicted would be 2016.

But unemployment fell immediately, so financial markets expected higher rates to be coming soon, so did not result in stimulation

Question 32

So BofE Modified Forward Guidance in 2014.

Answer 32

Tried to reassure and manage expectations

Said despite sharp fall in unemployment, still spare capacity to absorb before raising bank rate. And when rate would rise, it would be gradual.

(Didn’t help much; many interviews and speeches doesn’t look good for communication and transparency, or their reputation as good forecasters, since unemployment predictions were largely wrong!)

Question 33

2016: actions following Brexit shock (4)

Answer 33

Bank rate 0.5% to 0.25% (so lower! Not higher like forward guidance!)

More QE - £60bn more. 435bn total.

Direct support to banks to lower costs and increase lending.

Banks not required to pay dividends or bonuses to staff in 2020.

Question 34

Causes of cost of living crisis

Answer 34

Brexit
Covid
Bottlenecks in supply chains
Energy price crisis (Russia Ukraine)

Question 35

Monetary policy report 2024

Answer 35

Inflation has fallen from 11% to 4%. Expected to fall below 2% in Spring, but think this is superficial due to fall in energy price

They will keep interest high to reach target of 2%

Question 36

Current interest rate is 5.25.

One member of wanted to cut rates from 5.25 to 5%. Why? (3)

Reasons to maintain at 5.25 (2)

Answer 36

Consumption is falling
Per capita income is falling.
Producer price inflation is falling.

Reasons to maintain
Real GDP falling due to supply side factors.
Inflation expected to fall, but should guard against false sense of security. (Inflation fall is superficial, will rise again due to persistent factors e.g services inflation, pay growth, tightened labour market)