Monetary Policy

Question 1

What is a deflationary/contractionary policy?

Answer 1

A deflationary policy is one designed to reduce aggregate demand e.g. an increase in interest rates.

Question 2

What is a government bond?

Answer 2

A government bond is a security issued by the government to fund its borrowing requirements.

Question 3

What is hot money?

Answer 3

Hot money is funds that are liable to rapid transfer from one country to another.

Question 4

What are interest rates?

Answer 4

Interest rates are the price/cost of borrowing or the reward for saving.

Question 5

What is the bank rate?

Answer 5

The bank rate is the interest rate that the bank of England pays on bank reserves and the rate it is prepared to lend short-term money to financial institutions.

Question 6

What is domestic demand?

Answer 6

Domestic demand is C+G+I

Question 7

What is net external demand?

Answer 7

Net external demand is X-M

Question 8

What are the 2 categories of assets?

Answer 8

The two categories of assets are financial assets (e.g. shares or bonds) and physical assets (e.g. property/housing)

Question 9

Chain of reasoning for the effect of a rise in interest rates on physical asset prices.

Answer 9

Increase in interest rates, increase in the cost of borrowing, fall in demand for housing, fall in house prices.

Question 10

Chain of reasoning for the effect of a rise in interest rates on financial asset prices.

Answer 10

Increase in interest rates, increase in saving, fall in demand for financial assets, fall in prices for financial assets.

Question 11

Chain of reasoning to argue that a rise in interest rates would increase household and business confidence.

Answer 11

Increase in interest rates, low inflation expectations, higher confidence that there won’t be a boom.

Question 12

Chain of reasoning to argue that a rise in interest rates would decrease household and business confidence.

Answer 12

Households: Increase in interest rates, fall in aggregate demand, worries about unemployment, fall in confidence
Businesses: Increase in interest rates, fall in revenue, fall in profits, fall in confidence

Question 13

Chain of reasoning for the effect of a rise in interest rates on the exchange rate.

Answer 13

Increase in interest rates, increase in hot money, increase in demand for £, increase in the value of £

Question 14

3 chains of reasoning for the effect of a rise in interest rates on consumption.

Answer 14

Increase in interest rates…

1: increase in savings, fall in consumption
2: less borrowing, fall in consumption
3: increase in existing debt, fall in discretionary income, fall in consumption.

Question 15

Chain of reasoning for the effect of a rise in interest rates on investment (not including the consumption ones).

Answer 15

Increase in interest rates, smaller difference between the rate of return on an investment and the rate of interest, less investment

Question 16

2 conflicting chains of reasoning for the effect of an increase in interest rates on government expenditure.

Answer 16

Increase in interest rates, increase in cost of borrowing to fund a deficit, fall in government spending to reduce budget deficit
BUT: increase in interest rates, higher unemployment, more benefit payments

Question 17

Chain of reasoning for the effect of an increase in the exchange rate on exports and imports (1 each)

Answer 17

X: Increase in exchange rate, increase in export prices relatively, fall in exports
M: Increase in exchange rate, fall in import prices relatively, increase in imports

Question 18

What factors impact the effectiveness of monetary policy on consumption and investment (6)?

Answer 18

• Confidence and interest rate elasticity of demand
• Government’s fiscal policy (expansionary or contractionary)
• Difficulty/ease of borrowing money
• Wage growth
• Wealth effect (e.g. remortgaging)
• Demographic factors (e.g. older population has a higher MPS)

Question 19

What is an open market operation?

Answer 19

An open market operation is when the Bank of England buys or sells securities from financial institutions, thus affecting banks’ liquidity.

Question 20

Chain of reasoning for the Bank of England reducing bank lending to slow down AD.

Answer 20

Increase in supply of bonds, fall in bond prices, increase in bond yield, increase in market rate of interest, fall in consumption and investment, fall in AD.

Question 21

What was Funding for Lending?

Answer 21

Funding for Lending was when the Bank of England let commercial banks borrow funds at a cheap rate for creating loans to households and firms. In 2014 it changed so that the funding was only available for lends going to firms.

Question 22

How would funding for lending affect saving?

Answer 22

Banks can borrow cheaply from the Bank of England and thus do not need as much funding from savings, meaning they can have lower savings rates.