Monetary Policy Flashcards
Monetary Policy
This involves the manipulation of the money supply and the rate of interest by the monetary authorities. The purpose of monetary policy is:
• Control the rate of inflation. UK inflation target of CPI 2% (+/-1)
• Maintain stable economic growth.
Tools of Monetary Policy
- Inflation target - The Bank of England is responsible for keeping inflation close to the target; an inflation target also helps to reduce inflation expectations.
- Interest rates - Interest rates influence economic activity through influencing the cost of borrowing.
- Quantitative easing - This occurs when the Central Bank electronically creates money to buy assets. This helps to reduce interest rates on bonds and increase the money supply. It was used in 2009-12 when lower interest rates were not enough to boost demand.
Tight Monetary Policy
This involves increasing interest rates to reduce AD:
- Higher interest rates makes borrowing more expensive, therefore consumers spend less on credit and firms will be less willing to invest by borrowing money.
- The cost of mortgages payments increase, therefore people have less disposable income, causing a fall in consumption.
- Saving money in a bank is more attractive therefore there is less spending in the economy.
- The exchange rate increases because more people want to save in countries with higher interest rates (this is termed ‘hot money flows’.) The appreciation in the exchange rate makes UK goods relatively more expensive, depressing domestic demand.
- Higher interest rates tend to reduce demand for buying houses, which causes lower house prices. Falling house prices causes a negative wealth effect, reducing consumer spending further.
Tight Monetary Policy diagram
- This diagram shows how higher interest rates reduce AD and therefore decrease inflation.
- However it is likely to conflict with other objectives such as lower growth, higher unemployment and increased government borrowing.
Evaluation of monetary policy in reducing Inflation
- If AD falls the effect on inflation depends upon the position of the economy and the slope of the AS curve, e.g. at full capacity higher interest rates will have a significant effect on reducing inflation
- It depends upon other variables affecting AD; e.g. if confidence is high, increased interest rates may not reduce inflation. Similarly, if confidence is low (e.g. in 2009) zero interest rates may not be sufficient to promote economic recovery.
- Higher interest rates will cause an appreciation in the exchange rate. This will reduce AD and reduce the price of imports, helping to reduce inflation further.
- If inflation is due to cost push factors (e.g. rising price of oil) we get higher inflation and lower output. It is difficult to solve both cost-push inflation and lower output through the use of interest rates. The MPC would have to choose either inflation or output to target.
Loose Monetary Policy
This involves reducing interest rates to promote economic growth.
• This will increase spending, investment and increase AD and therefore lead to higher real GDP (if there is spare capacity in the economy)
• However it may conflict with other macro economic objectives such as higher inflation and depreciation in the exchange rate.
The Role and Function of the Central Bank
- Maintain price stability.Their inflation target is CPI 2% +/- 1
- The issuing of notes and coins.
- The banker of the commercial banks.
- Acting as a lender of last resort. If commercial banks need to give money to their customers they can always borrow from the B of E.
- Setting interest rates. Every month the MPC meet to decide on base interest rates which will influence economic activity.
- Adopting unorthodox monetary policy measures such as quantitative easing – if necessary.
Benefits of the MPC setting Monetary Policy
- The MPC have been successful in keeping inflation close to its target.
- Low inflation is important for ensuring stable and continuous growth.
- The govt could always change the target if there was a shock to the economy.
- It was argued that the govt use to set interest rates depending upon political considerations, e.g. before an election, interest rates were often cut to increase growth. The independence of the MPC should avoid this problem.
Criticisms of The MPC approach
- An inflation target is not enough. If the MPC just targets inflation this may lead to lower growth or higher unemployment.
- If there are shocks to the economy such as higher oil prices this may increase inflation, making it difficult to keep it within the govts target.
- Fine control of monetary policy is not possible because it is difficult to get accurate information about the economy.
- Low inflation between 1997-07 could be due to other factors such as increased productivity, better technology and low prices of raw materials.
- The MPC were unable to prevent asset bubble and resulting credit crunch in 2007-2009. This shows limitation of relying on interest rates alone.
- Monetary policy alone may not be enough. Keynesians argue there is need for expansionary fiscal policy if we are in a deep recession, where low interest rates don’t boost demand.
How supply and demand for credit (funds) impacts the interest rates.
An increase in the supply of credit (funds) will reduce interest rates while a decrease in the supply of credit will increase them. The supply of credit is increased by an increase in the amount of money made available to borrowers. For example, when you open a bank account, you are actually lending money to the bank, which the bank can lend out to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the rate of interest decreases. Demanding more credit (not paying a bill on time) increases interest rates as it reduces the supply of credit.
