Monetary policy Flashcards
When was the new Monetary policy system introduced
in 1997 by the Labour party
What is the role of the government in the new system
The government sets an symmetrical inflation target, meaning it is as bad to undershoot as t overshoot. Currently this is 2%
What is the role of the bank in the new system
The bank sets interest rates independently with the aim of achieving the governments target
How does the Bank operate interest rates
Through a Monetary Policy Committee, who meet 8 times a year
How many members does the MPC have
9 members who each have 1 vote
This comprises of 5 Bank officials and 4 outside experts (who are appointed for 3 year terms)
What report does the MPC produce
A quarterly report called the Monetary policy report, which describes the state of the economy and explains its conduct of monetary policy
What does the MPC do if they miss the target of 2%
- If missed by more than 1%, governor has to write a published open letter every 3 months to the chancellor explaining why, until inflation drops back down within a 1% margin of error
When the inflation rate deviates due to a supply side shock, the Bank can use its judgement to decide how quickly to get back to 2%. Generally, they would try get back within 2 years, which it calls the medium-term
How does the MPC determine the output gap of the economy
- They find evidence about the current and likely future growth of AD, looking at all the components in turn
- They estimate the full capacity of the economy by looking at changes in productivity levels and the size of the active labour force
This is how they judge future demand-pull inflation
How does analyse future cost-push inflation
- Trends in international food and raw material prices
- Changes in the exchange rate (if imports or exports are more expensive)
- Recent wage settlements (if wages go up, firms costs rise)
Why does the MPC look at the medium term for inflation caused by supply side shocks
Supply side shocks cause both loss in GDP and inflation, and Bank can’t fix both of these at the same time with interest rates.
Therefore, they first reduce interest rates to boost growth as long as inflationary pressure will go within 2 years
How does the MPC know that inflation will drop back down in the medium term
Because inflation is the annual rate of change of GPL so if GPL rises for a year and then stays constant for a year inflation will rise at first and then become 0
Therefore, if the supply side shock will only have a short term impact, the bank can lower interest rates with the confidence that they will fall in the medium term
What is the transmission mechanism
The term used to describe the routes by which monetary policy affects the economy
What are the 4 main impacts of the MPC changing the bank/base rate
1.Influences the rates of interest set by commercial banks (market rates)
2. Affects household wealth by influencing asset prices in housing and stock market
3. Affects the confidence of households/firms
4. Affects the exchange rate
How do changes in interest rates impact market rates
- The bank/base rate is the rate at which the Bank of England lends money to commercial banks
- Commercial banks will change their savings and loan rates as a result
i.e. lower bank rate means generally lower interest rates in the economy
How do changes in interest rates impact asset prices
- Lower interest rate means more disposable income for households and higher expected profits for firms
- Demand for housing and stocks goes up, leading to price rises
and vice versa
How do changes in interest rates impact expectations/confidence
Lower interest rate means households and firms are more confident about future economic growth
How do changes in interest rates impact the exchange rate
- Lower (relative) interest rate means less hot money inflows into UK savings accounts
- Value of pound falls, leading to a lower exchange rate
What is the key evaluation point when discussing monetary policy in the exam
Time lags:
- Economists think it takes about 18-24 months for a change in the bank rate to impact inflation.
- This is also why the MPC looks at the medium term when making decisions
What is an example of a recent cut in interest rates by the MPC
Interest rates were cut from 5.25% to 0.5% in 2009 after the financial crisis
What are the ways that consumption is affected due changes in the bank rate rate
- Cost of loans and mortgage (market rates)
- Consumption vs saving opportunity cost (market rates)
- Housing market (asset prices)
- Growth expectations
Explain the effects of lower loan and mortgage costs on consumption due a lower bank rate rate
Means more disposable income available to spend as less is spent on borrowing so marginal propensity to consume rises
However, mortgage doesn’t fall for a fixed mortgage
Explain the changes to the consumption vs saving opportunity cost due a lower bank rate rate
- Opportunity cost of consuming is lower so savings ratio falls. This is known as the positive substitution effect
- However, less interest made on savings account so people who are saving up for something have to save even more now and consume less. This is called the negative income effect
Economist believe the positive substitution effect outweighs the negative income effect so consumption increases
Explain how consumption is affected by increased value of asset prices caused by lower interest rates
- Positive wealth effect where rising wealth makes them more confident in taking financial risks like consumption
- Equity withdrawal where households borrow against their rising wealth, and they use the borrowed money for consumption
Explain how consumption is affected by increased growth expectations caused by lower interest rates
Means consumers are more confident about future job security, so willing to take more risk such as consumption
What are the ways that investment is affected due changes in the bank rate rate
- changes to cost of investment
- growth expectations
Explain how investment is affected due to changes in the cost of investment caused by lower interest rates
- decreased cost of borrowing may make the firm more likely to invest
- however, less interest made on retained profits may discourage some firms
Explain how investment is affected due to increased growth expectations caused by lower interest rates
- Increased confidence in the economy means businesses animal spirits rise, leading to accelerator effect, boosting investment
How do changes to the exchange rate caused by lower interest rates affect AD and SRAS
- Hot money flows out so weaker pound and weaker exchange rate
- Weaker pound means exports cheaper and imports more expensive
- AD shift out as X-M increase
- SRAS shift in as imports expensive so cost of production rises
What is the likely overall effect on AD as a result of lower interest rates
AD shifts out (with a time lag)
and vice versa if high interest rates
What are 5 other evaluation points for whether lower interest rates would actually boost growth
- If animal spirits are very low in the economy, i.e. after the financial crisis, lower interest rates may not work as firms and households are still pessimistic
- The bank might need to cut interest rates below 0 but can’t
- At some point, negative income effect may be > positive substitution effect
- People may go into a lot of debt so the bank may not want to increase interest rates as it may burst the debt bubble
- Banks make very little profit if the interest rates they charge borrowers and pay to savers both converge on 0, so they won’t be able to grow by lending to the private sector
What are the innovate monetary policy instruments used due to the limitations
- Quantitative easing
- Forward guidance
What are the stages of quantitative easing
- The central bank creates money electronically
- They use this money to buy bonds from financial institutions, increased demand for bonds causes price to go up so yield is lowe
- The financial institutions spend the money they get on other assets like corporate bonds and shares (they don’t buy bonds as the yield is low)
- This boosts the stock market, causing firms to have more money to invest and causes a positive wealth effect for households
- As money supply has increased, more credit available so commercial banks loan more at lower interest rates
- Overall boosts AD when traditional monetary policy isn’t working
How effective has QE been
- Since 2009, the stock market has risen very strongly and banks have had an extra £435bn to support lending
- However, QE has increased wealth inequality as rich people own more of the assets that have gone up in price
Explain forward guidance
- Instead of just stating the new bank rate, since 2013, the MPC gives an idea of interest rates in the medium term and why they will happen
- The aim is to boost confidence in the longer term economy, to encourage investment and consumption i.e. reassure firms that monetary policy will remain expansionary
Has forward guidance been successful
- Probably boosted confidence and benefited investment and consumption
- However, not as big an effect on AD compared to QE and lower interest rates because it only makes a difference if it tells people something they don’t already believe
Describe the 3 reasons why the new bank independence has been successful
- Interest rates are changed more quickly and decisively
- Bank has high credibility
- There is an open public debate due to the inflation report so public economic awareness has increased
Describe the Fischer’s equation or quantity theory of money
MV = PT
where M is the money supply, V is the velocity of circulation in the economy, P is the general price level and T is real GDP
LHS represents how much money is in circulation and the RHS represents AD
Who believed in the Fischer equation
Monetarists i.e. thatcher, who believed that the money supply (M) is proportional to the GPL (P) as they think V and T are quite constant
Thatcher based her monetary policy of the Fischer equation as she changed the money supply to control inflation
Why was Thatcher’s monetary policy changed
- V falls as people save and buy assets with their money instead of just consuming
- Therefore, V was quite volatile
- There wasn’t a very direct relationship between money supply and GPL
- Therefore, from the mid 80s the government started changing interest rates as it was a more reliable way of controlling inflation
