Monetary Policy

Question 1

Monetary Policy is about Controlling Money

Answer 1

1. Monetary policy involves making decisions about interest rates, the money supply and exchange rates.
2. Monetary policy has a huge affect on AD - its a demand-side policy
3. Most important tool of monetary policy is ability to set interest rates. Changes to interest rates affect borrowing, saving, spending and investment.
4. Interest rates also affect the other components of monetary policy - the money supply and exchange rates. E.g. a high interest rate can restrict the money supply as there’ll be less demand for loans.
5. Monetary policy can either be contractionary or expansionary:
   - Contractionary monetary policy = involves reducing AD using high interest rates, restrictions on the money supply and a strong exchange rate.
   - Expansionary monetary policy = involves increasing AD using low interest rates, fewer restrictions on money supply, and a weak exchange rate.
6. As with demand-side fiscal policy monetary policy can’t help achieve all of a government’s macroeconomic objectives simultaneously -there’s a trade-off. E.g. using monetary policy to increase economic growth and reduce unemployment may mean increasing inflation and worsening the current account of the b of p.
7. In the UK, the main aim of monetary policy is to ensure price stability - i.e. low inflation. But is also has the aims of promoting economic growth and reducing unemployment.

Question 2

Interest Rates are set by the Monetary Policy Committee (MPC)

Answer 2

1. The monetary policy committee (MPC) of the Bank of England sets interest rates in order to meet the inflation target that is set by the govt - this target is currently 2% inflation, as measured by the Consumer Price Index (CPI). This is known as inflation rate targeting.
2. The MPC has a symmetric target - if the inflation rate misses the 2% target by more than 1% in either direction, then the governor of the Bank of England has to write to the Chancellor.
3. So if the MPC believed that inflation was likely to go above 3% with current interest rates, it would increase the official rate of interest (sometimes called the Bank Rate or Base Rate) to reduce AD and keep inflation close to 2%.
   - Some central banks have an asymmetric inflation target. E.g. The European Central Bank (ECB) aims to keep inflation close to but below 2%.
4. A low rate of inflation that’s stable and credible stops higher rates of inflation becoming embedded in the economy. It also helps a government achieve macroeconomic stability - a high or rapidly changing rate of inflation creates uncertainty, prevents investment, and makes it difficult to plan for the future.
5. To achieve this stability and credibility, the Bank of England is independent and accountable:
   - The Bank of England’s independence means that interest rates can’t be set by the govt at a level that will win votes, but which might not be right for the economic circumstances at the time.
   - The Bank of England is accountable - if the inflation rate is more than 1% away from the target rate, then the Bank’s governor must write an open letter to the Chancellor explaining why, what action the MPC is going to take to deal with this, and when they expect inflation to be back to within 1% of the target.
6. Although price stability is the main objective of monetary policy, the Bank of England must pursue this in a way that doesn’t harm the government’s other macroeconomic policy objectives (e.g. economic growth).
7. When the MPC is making a decision on interest rates it will look at important economic data, such as:
   - house prices,
   - the size of any output gaps
   - the pound’s exchange rate
   - the rate of any increases or decreases in average earnings
8. The MPC has to consider interest-rate changes very carefully, since these changes can have a huge effect

Question 3

A rise in interest rates can cause a ripple effect usually

Answer 3

1. Even very small changes in interest rates can create a ‘ripple effect’ through the whole economy.
2. Here are some likely effects of an increase in interest rates:
   - less borrowing
   - less consumer spending
   - less investment by firms
   - less confidence among consumers and firms
   - more saving
   - a decrease in exports
   - a increase in imports
3. A decrease in interest rates will have the opposite effects
4. However, when ppl are particularly pessimistic about the future state of the economy, they may prefer to keep hold of the money they already have, and they’re unlikely to want to borrow any more. In this case, lowering interest rates won’t create the above ‘ripple effect’, and monetary policy will become ineffective. This situation = liquidity trap.

Question 4

Markets affect interest rates too

Answer 4

1. The bank rate is the lowest rate at which the Bank of England will lend to financial institutions. But it isn’t the rate of interest that you’d pay if you applied to a high-street bank for a mortgage or took out a bank loan.
2. However, these various types of interest rates are linked - if the Bank Rate goes up, then that will usually => interest rates charged on mortgages and bank loans also increasing. The same happens in reverse if the Bank Rate falls - i.e. other interest rates in the economy will also fall.
3. But the Bank Rate is not the only thing that affects these ‘market’ interest rates.
4. E.g. banks often need to borrow the money that they then lend out to firms and consumers from other lenders. If lots of banks are trying to borrow money at the same time, then they’ll have to pay a higher rate of interest themselves, which will affect the cost of mortgages and loans they offer to consumers.

Question 5

Interest Rates affect Exchange Rates

Answer 5

1. When interest rates are high in the UK, big financial institutions want to buy the pound. They do this so that they can put their money into UK banks and take advantage of the high rewards for savers brought about by the high interest rates. This is likely to be a short-term movement of money and it’s called ‘hot money’.
2. An increased demand for the pound means its price goes up - i.e. the pound’s exchange rate rises.
3. Unfortunately, a high exchange rate makes UK exports more expensive.
   - suppose the exchange rate changed to £1 = $4 (i.e. the pound’s exchange rate goes up, or the pound becomes stronger).
   - someone in the USA would now have to spend $4 to pay for the same £1 pen. Remember, the pen’s price in the UK hasn’t changed at all - this extra cost to the person in the USA is all to do with the cost of buying pounds.
4. When this happens exports go down, worsening the balance of payments.
5. For the same reason, high UK interest rates mean imports from abroad become cheaper. Again this worsens the current account.
6. And remember… imports are a leakage in the circular flow of income, and so more spending on imports means a reduction in AD.
7. When UK interest rates fall, the opposite happens:
   - The exchange rate of the pound falls.
   - UK exports increase (as UK goods become cheaper) and imports decrease (as foreign goods become more expensive)
   - The balance of payments improves.

Question 6

The Transmission Mechanism shows the effect of Interest-Rate Changes

Answer 6

The knock-on effects that a change to the official Bank Rate can have are best shown by the transmission mechanism - this is shown in the diagram below. The end result of any change in the official Bank Rate will be a change to the level of inflation.
* Look at the diagram in the revision textbook*
E.g.
- Suppose the Bank of England reduces the official bank rate
- Other interest rates will probably fall too as a result
- This affects asset prices - these are likely to rise (since ppl tend to buy more assets when interest rates are low).
- Ppl and firms will also generally feel more confident about the future, which will make them want to spend or invest - => an increase in domestic demand.
- Lower interest rates will also generally mean a fall in the exchange rate…
- … which leads to an increased demand for UK exports.
- The result of all this is that total demand in the economy increases.
- The price of imports will also generally rise as a result of the fall in the exchange rate.
- The end result is that there’s upwards pressure on the level of inflation in the economy.

Question 7

Monetary policy needs to look about Two Years into the Future

Answer 7

1. The effect of changing interest rates is not felt straight away - it takes time for the effects to feed through the transmission mechanism shown in the diagram above.
2. For example, reducing interest rates won’t usually cause a sudden surge in investment or house buying.
   - Firms plan investment projects very carefully - it can take months or years before they increase their spending.
   - House buying can also take a long time - ppl need to find a suitable home, and the purchase can take a long time too. Fixed-rate mortgage holders won’t notice the effect of an interest rate change until their fixed-rate period ends.
3. In fact, the time lags between changes in the Bank Rate and its effect on the economy can be v long indeed.
   - The maximum effect on firms is usually felt after about 1 year.
   - The maximum effect on consumers is usually felt after about 2 years.
4. So the Bank of England has to look up to two years into the future when it’s making a decision about interest rates.