Monetary Policy

Question 1

What is it

Answer 1

The use of interest rates and the money supply to influence levels of AD

Question 2

Monetary transmission mechanism

Answer 2

Money supply (+) - interest rate (-) - investment (+) saving (-) - AD(+) GDP(+) prices (+)

Exchange rate mechanism

Money supply (+) - D for foreign assets (+) - interest rate (-) - exchange rate (-) - exports (+) imports (-) AD(+)

Question 3

Frequently used methods to control interest rates

Answer 3

Open market operations
Variable central bank lending
Variable minimum reserve ratios

Question 4

Gilts

Answer 4

U.K. Bonds issued by U.K. Gov

Treasury bill (same but US)

Question 5

Repos

Answer 5

Repurchase agreement

Form of short term borrowing for dealers in govt securities where the borrower agrees to buy back at a fixed date at a a fixed price

Borrower sells bond to lender for cash then buys it back for cash + interest

Question 6

Open market operations

Answer 6

Central bank operations In the gilt repo market to raise IRs

If banks are short of liquidity they sell gilts through gilt repos

If banks have surplus liquidity they buy bills

They change interest rates by changing the repo rate

Question 7

Open market operations limitations

Answer 7

Problems with controlling interest rates

Inelastic demand for loans
Unstable demand for money
Possible conflict between domestic goals and exchange rate goals

Question 8

Other forms of intervention

Answer 8

Variable central lending to banks

• The central bank can change directly the amount of liquidity it is willing to lend out to bank
• This will affect the banks ability to issue new loans
• more liquidity - more loans (expands monetary base)
• less liquidity - fewer loans (contracts monetary base )

Variable minimum reserve ratios
-higher reserves - less money to lend out for banks-fewer loans- smaller multiplier effect

Lower reserves - less money to lend out for banks- more loans - bigger multiplier effect

Question 9

Monetary policy post 2008

Answer 9

Interest rates were forced to zero

Int rates were cut from 5% in sep 2009 to 0.5 in march 2009, lowest in over 300 years

Still wasn’t enough to kick start economic activity, consumption and lending

Question 10

Quantitative easing

Answer 10

1) Central banks create money
2) To buy bonds from financial institutions
3) which reduces interest rates
4) leading businesses to borrow more
5) so they spend more and create jobs
6) to boost the economy

Question 11

Summary

Answer 11

Monetary policy is a valuable tool to deal with business cycles fluctuations

It’s effectiveness is limited

Question 12

Monetary policy post 2008

Answer 12

FED injected $3.7 trillion between 2008-2015

The ECB has injected over 1 trillion euros

The UK injected £375 billion between 2008-2015

August 2016 the BofE offered to buy an extra of £60billion uk gov bonds
And £10 billion corporate bonds to ease brexit uncertainty

Question 13

How did it pan out

Answer 13

Inflation still low (in line with Keynes school of thought )

Oil price movements have also been conducive to low inflation

Stock market buoyant

Criticism that much of this new money ended up in the capital markets and not in the real economy

Unemployment at historic lows

Negative or zero wage growth