Monetary policy

Question 1

When was the new Monetary policy system introduced

Answer 1

in 1997 by the Labour party

Question 2

What is the role of the government in the new system

Answer 2

The government sets an symmetrical inflation target, meaning it is as bad to undershoot as t overshoot. Currently this is 2%

Question 3

What is the role of the bank in the new system

Answer 3

The bank sets interest rates independently with the aim of achieving the governments target

Question 4

How does the Bank operate interest rates

Answer 4

Through a Monetary Policy Committee, who meet 8 times a year

Question 5

How many members does the MPC have

Answer 5

9 members who each have 1 vote
This comprises of 5 Bank officials and 4 outside experts (who are appointed for 3 year terms)

Question 6

What report does the MPC produce

Answer 6

A quarterly report called the Monetary policy report, which describes the state of the economy and explains its conduct of monetary policy

Question 7

What does the MPC do if they miss the target of 2%

Answer 7

• 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

Question 8

How does the MPC determine the output gap of the economy

Answer 8

• 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

Question 9

How does analyse future cost-push inflation

Answer 9

• 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)

Question 10

Why does the MPC look at the medium term for inflation caused by supply side shocks

Answer 10

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

Question 11

How does the MPC know that inflation will drop back down in the medium term

Answer 11

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

Question 12

What is the transmission mechanism

Answer 12

The term used to describe the routes by which monetary policy affects the economy

Question 13

What are the 4 main impacts of the MPC changing the bank/base rate

Answer 13

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

Question 14

How do changes in interest rates impact market rates

Answer 14

• 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

Question 15

How do changes in interest rates impact asset prices

Answer 15

• 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

Question 16

How do changes in interest rates impact expectations/confidence

Answer 16

Lower interest rate means households and firms are more confident about future economic growth

Question 17

How do changes in interest rates impact the exchange rate

Answer 17

• Lower (relative) interest rate means less hot money inflows into UK savings accounts
• Value of pound falls, leading to a lower exchange rate

Question 18

What is the key evaluation point when discussing monetary policy in the exam

Answer 18

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

Question 19

What is an example of a recent cut in interest rates by the MPC

Answer 19

Interest rates were cut from 5.25% to 0.5% in 2009 after the financial crisis

Question 20

What are the ways that consumption is affected due changes in the bank rate rate

Answer 20

• Cost of loans and mortgage (market rates)
• Consumption vs saving opportunity cost (market rates)
• Housing market (asset prices)
• Growth expectations

Question 21

Explain the effects of lower loan and mortgage costs on consumption due a lower bank rate rate

Answer 21

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

Question 22

Explain the changes to the consumption vs saving opportunity cost due a lower bank rate rate

Answer 22

• 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

Question 23

Explain how consumption is affected by increased value of asset prices caused by lower interest rates

Answer 23

• 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

Question 24

Explain how consumption is affected by increased growth expectations caused by lower interest rates

Answer 24

Means consumers are more confident about future job security, so willing to take more risk such as consumption

Question 25

What are the ways that investment is affected due changes in the bank rate rate

Answer 25

• changes to cost of investment
• growth expectations

Question 26

Explain how investment is affected due to changes in the cost of investment caused by lower interest rates

Answer 26

• decreased cost of borrowing may make the firm more likely to invest
• however, less interest made on retained profits may discourage some firms

Question 27

Explain how investment is affected due to increased growth expectations caused by lower interest rates

Answer 27

• Increased confidence in the economy means businesses animal spirits rise, leading to accelerator effect, boosting investment

Question 28

How do changes to the exchange rate caused by lower interest rates affect AD and SRAS

Answer 28

• 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

Question 29

What is the likely overall effect on AD as a result of lower interest rates

Answer 29

AD shifts out (with a time lag)

and vice versa if high interest rates

Question 30

What are 5 other evaluation points for whether lower interest rates would actually boost growth

Answer 30

• 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

Question 31

What are the innovate monetary policy instruments used due to the limitations

Answer 31

• Quantitative easing
• Forward guidance

Question 32

What are the stages of quantitative easing

Answer 32

1. The central bank creates money electronically
2. They use this money to buy bonds from financial institutions, increased demand for bonds causes price to go up so yield is lowe
3. 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)
4. This boosts the stock market, causing firms to have more money to invest and causes a positive wealth effect for households
5. As money supply has increased, more credit available so commercial banks loan more at lower interest rates
6. Overall boosts AD when traditional monetary policy isn’t working

Question 33

How effective has QE been

Answer 33

• 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

Question 34

Explain forward guidance

Answer 34

• 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

Question 35

Has forward guidance been successful

Answer 35

• 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

Question 36

Describe the 3 reasons why the new bank independence has been successful

Answer 36

• 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

Question 37

Describe the Fischer’s equation or quantity theory of money

Answer 37

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

Question 38

Who believed in the Fischer equation

Answer 38

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

Question 39

Why was Thatcher’s monetary policy changed

Answer 39

• 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