Monetary Policy Flashcards
less effective bc time lag + when BoE increase base rate…+ asset price
Monetary Policy Evaluation - Changing interest rates and the transmission mechanism
and market prices change first. e.g asset prices fall
(this can be used for both contractionary monetary policy and expansionary monetary policy. However, makes more sense for contractionary)
* However, the effectiveness of contractionary monetary policy in order to reduce reduce inflation may be less effective due to the time lag.
* When the bank of england increase the base rate, for example, 3% to 5%, in order to effect the wider macroeconomy i.e reduce inflation it must undergo a transmission mechanism before it has any impact on inflation.
* For instance, when the Bank of England decides to increase the base rate, assets prices and market prices will first change (not all components). For example, increased interest rates will mean that asset prices will fall due to decreased demand as saving is now relatively more rewarding and attractive.
* As a result, domestic demand and total demand in the economy will fall as investment (I) is a component of aggregate demand (ceteris paribus).
* This then decreases the price level reducing domestic inflationary pressure (ceteris paribus) which finally reduces demand-pull inflation.
* The Bank of England estimates that a change in the bank rate takes 2 full years to have the full impact of inflation.
* This is an issue as if inflation rates are too high and it takes a relatively long amount of time to decrease them cost of living will rise which in turn could increase povery (ceteris paribus) therefore contractionary monetary policy to reduce inflation, particularly in the short-term, may not be desirable.
BoE create digital mon + purchases bonds + increase in D for bonds
Quantitative Easing - Standard An
P1-P2 exp + yields fall + e.g + investors move + banks remain comp…
(Quantitative easing is expansionary monetary policy - the way I am going to write it here is for 1 point - if you got this as a 15 marker you would do this slightly differently. You would fully explain what happens in the bond market….Then go with the explanation of AD/AS)
(For this use two diagrams)
* With permission with the treasury, the Bank of England creates digital money, thus increasing the money supply (ceteris paribus).
* With this newly-created money, the Bank of England purchases (mostly) government bonds from secondary capital lmarkets from banks ad financial institutions. As a result, demand for bonds increases from D1-D2.
* At P1, there is excess demand of bonds so price increases from P1-P2.
* Government bonds have a fixed coupon and therefore as the price of bonds rises, the coupon is a smaller percentage of the price, so the yield of bonds fall. For example, a bond with a coupon of £50 at the price £1000 has a yield of 5% wheras at £1200 the yield is 4.17%.
* Consequently, investors will have a greater incentive to move to other markets which drives down the yields in those other markets too e.g shares. This effect repeats until saving in banks remains competitive at lower rates of interest.
* As a result, banks attract more savers as saving is now relatively more rewarding which in turn increases the amount of loanable funds banks possess.
* Banks now have more loanable funds, making it easier for them to lend money which can boost consumption and investment. These are components of aggregate demand. The aggregate demand curve will shift rightwards from AD1-AD2.
* Increased spending and employment will return inflation in the UK economy to its 2% target.
What is monetary policy?
Monetary policy is changes to the interest rates, money supply and the exchange rate in order to influence AD.
Why would the government/central banks use expansionary monetary policy?
- Increase inflation
- Increase growth
- Reduce unemployment
Why would the government/central banks use contractionary monetary policy?
- Reduce inflation
- Prevent asset/credit bubbles
- Reduce excess deby and promote saving
- Reduce current account deficit
What are some examples of the government using expansionary monetary policy?
(I am not going to make standard An on these because they are all straight forward I just need to know the reason and then talking about how that affects AD is simple)
* Interest rates - decreasing credit card interest rates (increasing consumption through decreasing borrowing costs for consumers) + decrease in saving interest rates (increasing consumption) + decrease the rate on business loans (increases investment).
* Money Supply - QE
* Exchange rate - weakening exchange rate.
Standard An - How decreasing interest rates affect the exchange rate leading to a rise in AD.
- If interest rates in the UK are lower. For example, a decrease in savings interest rates, then the reward (interest) for saving in the UK is lower and this can decrease the UK exchange rate.
- This is because, investors look for the best rate of return for their “Hot Money”. Since the savings interest rates have decreased in the UK, they may move their money into another country such as France that has relatively higher saving interest rates as there is a greater profit incentive to do so.
- In order to do this, investors have to convert their pounds sterling into Euros. As a result, there is excess supply of pounds which drives down the price i.e exchange rate.
- ….WPIDEC AN.
Expansionary Monetary policy Evaluation - Tradeoffs with macroeconomic objectives
- However, perhaps the government does not want to use expansionary monetary policy as it can cause tradeoffs with other macroeconomic objectives.
- If the government uses expansionary monetary policy then aggregate demand will rise, which, ceteris paribus, increases the price level.
- For example, if the government decrease savings interest rates, then there is a decreased incentive to save, as the reward for saving (interest) is lower. As a result, the average propensity to save in the economy falls (ceteris paribus), meaning that consumption in the economy rises as consumers can either save or spend their money.
- This is a component of aggregate demand, causing a rightwards shift in AD from AD1-AD2. This increases real national output and incomes from Y1-Y2, meaning that there is an increase in short-run economic growth.
- However, in using expansionary monetary policy to stimulate economic growth there is conflict with the other macroeconomic objectives.
- For instance, due to boosting economic growth, the general price level rises from Pl1-Pl2. As a result, the current account of the balance of payments will be worsened (ceteris paribus)……
Expansionary Monetary Policy Evaluation - Depends upon the size of the output gap
(I already have a flashcard for this in expansionary fiscal policy)
What are the disadvantages of the exchange rate appreciating?
- Lower growth - fall in net exports –> decrease in (X-M) –> decreases AD.
- Higher unemployment in exporting industries……consequences –> increased income inequality from people losing their jobs etc…
- Weaker current account position on the balance of payments due to decrease in export –> increasing the effects of crowding out.
What are some advantages of the exchange rate appreciating?
- Lower inflation - demand-pull and cost push inflation –> macroeconomic objectives….
- Cheaper imports - which increases living standards
What are some advantages of a depreciating exchange rate?
- Increase in short-run economic growth - net exports…..
- Increase in employment in exporting industries
What are some disadvantages of a depreciating exchange rate?
- Higher inflation - demand-pull and cost push inflation
Why would a government want to intervene in foreign exchange markets?
- Decrease exchange rate to increase employment
- Increase exchange rate to fight inflation
- Improve a current account deficit
How would the government influence the exchange rate
- Buy or sell domestic currency using currency reserves
- Change interest rates
