Monetary Policy

Question 1

Describe the relationship between bond prices and interest rates

Answer 1

Interest rates fall —> bond prices increases —> positive wealth effect
Interest rates rise —> bond prices fall —> negative wealth effect

Question 2

Define inflation targeting

Answer 2

Policy in which a central bank has an explicit target inflation rate for the medium term and announces this target to the public

Question 3

What are the benefits of inflation targeting

Answer 3

Transparency —> commitment to price stability means economic agents (mainly firms) are confident about future prices
Expectations —> credible inflation target means that economic agents will build this inflation rate into their behaviour (wages, prices)
Stability —> targeting creates certainty so increases investment

Question 4

What are the problems of inflation targeting

Answer 4

Target must be credible —> if not then agents will not adjust their expectations (can cause havoc with investment and wages)
Asymmetric targets —> some central banks only steps in to change interest if inflation is above target, but deflation is dangerous

Question 5

Explain the process of QE

Answer 5

Central bank buys assets with money created
Bonds bought from commercial banks by central bank
Increases money supply in the financial system
Encourages institutions to lend more to businesses and individuals

Question 6

What are the losses of QE

Answer 6

Lower interest rates depreciates the currency —> hot money flows + imported inflation (SRAS increases)

Question 7

When can QE be ineffective

Answer 7

Low business and consumer confidence
Extent of QE —> how much money created by central bank
Positive impact may be lessened due to demand-pull inflation reducing purchasing power
Classicals argue that the market automatically adjusts