Monetary Policy Flashcards
1
Q
Monetary policy
A
- It concerns the monetary (Money or currency) side of the economy through manipulation of interest rates
- It is a demand side policy that is primarily used to control inflation
- It can be effective in influencing aggregate demand in the short run, in turning affecting economic growth, unemployment, inflation and the balance of payments
- In the long run it has less impact but can help stimulate investment
2
Q
Instruments of monetary policy
A
- Manipulation of interest rates
- Printing money and quantitative easing (Where banks buy Government bonds to stimulate economic activity)
- Exchange rate manipulation
- It is primarily concerned with controlling inflation caused by excess demand
3
Q
The base rate
A
- The rate of interest charged by the central bank to commercial banks to borrow money overnight
- It is the most important interest rate in the UK financial system because it influenced other interest rates in the UK
4
Q
Monetary policy committee
A
A committee that makes the decisions about the base rate
5
Q
Macroeconomic policy
A
- The level of AD is impacted by monetary policy through transmission mechanism making it a demand side policy
- However since 1979 the UK government have preferred using monetary to fiscal policy to manipulate AD this is because:
- Fiscal policy can cause unsuitable levels of govt debt
- Monetary policy avoids “crowding out” - where govt spending simply displaces private sector spending
- Monetary policy allows consumers to decide where additional spending should take place
6
Q
Quantitative easing (QE)
A
- Increase money supply by creating new money which is used to buy functional assets held commercial banks
- The bank of England buys back from commercial banks and credit the bank accounts with newly electronically created money
- During the recession in 2009 interest rates became less effective as banks where reluctant to pass on rate cuts
- Keynes identified the situation as a ‘liquidity trap’ where interest rates a close to 0 and so it cannot be used to effectively encourage consumption and discourage saving
- The BoE implements it this has an effect on:
- Commercial banks
- Households
- Consumers
- Mortgages holders
- Firms
- Foreign currency traders
- Owners of govt bonds
- The market for loanable funds
7
Q
The process of QE
A
- The BoE buys government bonds (gilts) from the commercial banks and credit the banks accounts with Newley created money
8
Q
Impacts of (QE)
A
- Commercial banks have more money and so have more money to lend to households and businesses
- With increased supply of money, commercial interest rates will fall encouraging borrowing and discourage savings
- The increase in demand for gilts and bonds raise the prices this benefits all holders of such assets and stimulates a wealth effect
- Increased money supply and the lowering of the yield on bonds causes an increased demand for other assets such as shares and property raising there prices triggering the wealth effect
9
Q
The controversy of QE
A
- When it was first announced many economist worried it would trigger very high inflation
- The purpose of creating money and using it buy existing assets was designed such that QE could theoretically be ‘unwound’
- The BoE could sell the assets back to the banks and ‘destroy’ the money it receives for them meaning there is a reduction in the money supply back to the previous level - this process is called quantitative tightening (QT)
- The wealth effects of QE have been benefitted those with assets such as shares and bonds e.g. the wealthy
10
Q
Impact of monetary policy
A
- Interest rates are the key instruments designed to keep inflation within the governments target range - they do this by influencing the level of AD via the transmission mechanism
- Higher interest rates don’t tend to cause a in in GPL but rather lessen price rises that would otherwise have happened
- Higher interest rats are associated with ‘tightening monetary policy’
- With higher interest rates there is likely to be a reduced demand for money in the economy and so there will be less credit creation and therefore less money in the economy
- The use of interest rates is used to help ‘demand pull’ inflation
- Where inflation is ‘cost push’, then higher interest rates will strip out any demand pull element
11
Q
What is money: The four functions
A
- A medium of exchange
- A Unit of account (measure value)
- A store of value
- A standard of deferred payments
12
Q
Types of money
A
- Narrow Money - Notes and coins
- Near money - Credit and debit cards
- Broad money - Narrow money + Near money
13
Q
Characteristics of money
A
- Acceptability - Money must be accepted by everyone.
- Durability - Money must not rot or perish so its keeps its value
- Divisibility - Money must be split into units of differing values to be a measure of value
- Portability - Money must be easy to carry
- Uniformity - Money of equal value must be identical in all respects
- Scarcity - Money supply must be limited to keep its value
- Difficult to forge - Money must be difficult to counterfeit so people keep its faith in it
14
Q
Formal measures of the money supply
A
- M0 - Notes and coins in circulation + commercial banks deposit with bank of England
- M4 - Widest measure: Cash and retail and wholesale deposits in banks and building societies, plus certificates of deposit
- M0 and M4 are the only two official UK measures. M0 about 2% of M4
15
Q
Demand for money
A
- Determined by income and interest rates
- (Higher interest rates, lower demand for money)
- ## How much households and firms choose to hold in the form of money as opposed to other financial or physical assets
16
Q
Households holding money
A
- Transaction demand - To buy things
- Precautionary demand - In case they want to buy more things than planned
- Speculative demand - What long term investments to make
17
Q
Barter
A
Swapping one good for another good without the use of money
18
Q
Bond
A
A form of borrowing by firms or government where money is borrowed which will be repaid at a fixed point in the future and regular interest payments will be made at a fixed rate
19
Q
Liquidity
A
The degree to which an asset can be converted into money without capital loss and within a short space of time
20
Q
Liquidity preference schedule
A
The demand for money curve showing the relationship between the demand for money and the rate of interest
21
Q
Liquidity trap
A
Where interest rates are so low that the demand for money is perfectly interest inelastic and central banks are unable to lower interest rates any further to stimulate borrowing in the economy
22
Q
Contractionary monetary policy
A
- Measures taken by the bank of England to control the money supply this can be done by INCREASING INTEREST RATES
23
Q
Expansionary monetary policy
A
Measures taken by the bank of England to control the money supply this can be done by REDUCING THE BASE RATE
