monetary policy

Question 1

What is monetary policy?

Answer 1

-Use of interest rates, changes in the money supply, and exchange rates to affect AD and therefore economic growth and inflation
-Controlled by the Bank of England

Question 2

Interest rates

Answer 2

-Base rate - interest rate set by BoE - cost of borrowing from BoE for commercial banks
-Market rate - rates of interest available to borrowers and savers which vary depending on risk, amount borrowed /saved, access to savings etc - they typically follow the Bank base rate up/ down

Question 3

Expansionary monetary policy

Answer 3

• lower interest rate
• more incentive to spend, less incentive to save
  -encourages spending/ borrowing, mortgages, loans, credit cards
• encourages firms to borrow - capital investment
  -injection into circular flow
• boosts AD - consumption and investment increase
  -Higher level of RGDP and higher price level - demand-pull inflation occurs

Question 4

Monetary policy transmission mechanism

Answer 4

-High interest rates increase cost of borrowing
-This slows consumption and investment
-Reduces AD and upward pressure on retail prices
-Currency appreciates - imports cheaper - less inflation
-Increase return on savings so encouraged
-negative wealth effect- increased mortgages

Question 5

MPC

Answer 5

-monetary policy committee
-9 members meet 8 times a year to set base rate and decide whether QE/QT is needed- governor has casting vote

Question 6

Factors MPC consider when determining exchange rate

Answer 6

-Growth rate
-Forecast of inflation
-Exchange rates
-Business confidence

Question 7

Quantitative Easing

Answer 7

-increase money supply
-encourage com banks to lend at cheaper interest rates to smaller businesses
-form of exp. MP
-Used to stimulate AD at times of historically low interest rates

Question 8

How QE works

Answer 8

-CB creates new money to buy large amount of financial assets like government bonds from financial institutions
-price of bonds increase, the yield will fall
-The financial institutions can loan out this money or invest this money elsewhere (riskier corporate bonds/shares) which can cause wealtth effect to stimulate increase in consumption
-Coorporate bonds - reduce cost of borrowing- yield is less/smaller interest rates
-com banks reduce interest rates-increased liquidity- pass on lower rates
-The UK did £375bn of QE 2009-12

Question 9

Evaluation

Answer 9

-Demand-pull inflation - conflict of objectives
-Liquidity trap- consumers hoard cash so do not need to continue borrowing money- fears of losing job
-negative impact on savers - if inflation higher than nominal interest rates - return is less than rise in prices
-Time lags - 18 months to 2 years

-Confidence is high - more effective- people respond to incentives
-com banks may not pass on savings
-banks may become more risk averse so people could be unable to borrow - 2008 financial crisis