Monetary Policy Flashcards
Define monetary policy
Monetary policy is undertaken by the Bank of England and involves controlling the supply of money in the economy to achieve macro economic goals
Define the financial sector
The financial sector refers to businesses, firms, banks and institutions providing financial services and supporting the economy
It encompasses several industries including banking and investment, mortgage etc
What are commercial banks?
A business based on giving people a safe place to save their money in return for which households and firms will be paid interest: a reward for lending the bank their money
These also loan money to households and firms
Developed economies use these to manage transactions when they shift away from cash
What are investment banks?
These aim to facilitate various financial transactions for corporations, governments and large organisation. These focus on serving institutions and high net worth clients unlike retail banks
They assist corporations, governments and other institutions in raising capital by facilitating the issuance of stocks and bonds which enables public and private investment
They also engage in trading activities on behalf of clients by buying and selling financial instruments in financial markets such as stocks, bonds derivatives etc
What are central banks?
These are an arm of government but have a high degree of independence. In the UK this is the Bank of England who’s main role is to manage the money supply
Its main tool for this is setting the base rate. As it is the bank of banks, when it changes the base rate commercial banks will follow suit and change their interest rates.
Other functions: regulatory function= sets rules for financial institutions
Lender of last resort = support financial institutions in trouble
Maintain sovereign reserves = the UK’s emergency funds
What are the four functions of money?
1) Medium of exchange - to facilitate transactions
2) Unit of account - provide a common measure for the value of goods and services
3) Store of value - money must hold its value over time to be a medium of exchange
4) Means of deferred payment - deferred payments are loans, mortgages and insurance contracts
What determines the interest rates a bank will charge?
1) Creditworthiness - interest rates vary proportionally with the level of risk for the lender
2) Collateral - if the borrower defaults the lender will receive the assets value such as mortgage the bank can take the house
3) Size of the loan - low rates are charged on large loans as an incentive to firms and households as it’s more profitable
4) Term of loan - low rates charged for long term loans as it’s a steady stream of revenue for the bank
Chain of reasoning for reduced interest rates
- The Bank of England will reduce interest rates if there is insufficient demand in the economy: deflationary pressure and unemployment caused by a demand side shock such as a recession
- Commercial banks save with and borrow from the Bank of England so they are obliged to change their interest rates in line with the Bank of England
- Consumer banks charge less to consumers who are borrowing, give less reward for saving and reduce the cost of some existing debt (debt with a variable rate)
- Consumers incentivised to engage in credit based spending, less incentivised to save and may have more money as the cost of existing debt reduces
- Firms are also incentivised to borrow to invest and its cheaper for governments to borrow
- AD shifts right, increased price level, increased derived demand for labour so unemployment reduced
Chain of reasoning for increased interest rates
- Too much demand relative to supply in the economy will prompt this
- Bank of England increases the base rate, commercial banks are obliged to follow as they save and borrow from it
- Consumers are charged more for borrowing, give more reward for savers and increase the cost of some (variable rate) existing debt
- Decreased consumer spending, more saving by firms and households, expensive for governments to borrow and firms discouraged from borrowing to invest
- AD shifts left, decrease demand led economic growth decreasing price level and demand pull inflation
Define transmission mechanism
It describes how changes made by the central bank to its base rate flow through economic activity and the inflation rate
Describe the market rate section of the transmission mechanism
- Bank of England decreases base rate
- Market rate (commercial banks rate) decreases
- Less saving
- More borrowing
- Lower debt costs
- More domestic demand
- More inflationary pressure
Describe the asset prices section of the transmission mechanism
- Bank of England reduces the base rate
- Asset prices rise because cheap mortgages increase demand
- Creates a wealth effect (people feel richer)
- Increases domestic demand
- Increases inflationary pressure
Describe the expectations section of the transmission mechanism
- Bank of England decreases the base rate
- Economic expectations rise
- Consumer confidence rises
- Increased domestic demand
- Increased inflationary pressure
Describe the exchange rate section of the transmission mechanism
- Bank of England decreases the base rate
- The exchange rate depreciates
- Fewer imports
- More exports
- More exports and fewer imports means more net external demand
- More net external demand causes inflationary pressure
- Import prices rise causing Inflationary pressure
Define quantitative easing
This is when there is a lack of demand in the economy and low interest rates have failed to stimulate demand: can be due to low animal spirits, or there is contractionary fiscal policy (austerity) happening at the same time
This was used during the 2008 financial crisis £500bn of quantitative easing
