Monetary Policy

Question 1

Monetary Policy

Answer 1

When the central bank changes the base interest rate or the money supply in order to influence aggregate demand within an economy.

Question 2

Base Interest Rate

Answer 2

The interest rate, set by the Bank of England, showing the rate at which they will lend money to highstreet banks.

Question 3

Expansionary Monetary Policy

Answer 3

Decreasing the base interest rate in order to increase aggregate demand and increase the rate of inflation.

Question 4

Contractionary Monetary Policy

Answer 4

Increasing the base interest rate in order to decrease aggregate demand and decrease the rate of inflation.

Question 5

recession

Answer 5

A recession is two consecutive quarters of negative economic growth.

Question 6

Which policy is the Bank of England likely to have used in order to bring the UK economy out of recession?

Answer 6

During a recession, the Bank of England wants to expand the economy and increase AD. This means pursuing expansionary monetary policy by decreasing the interest rate. A lower interest rate encourages consumers to spend rather than save and it encourages firms to borrow to invest. This will increase AD and inflation.

Question 7

Why did the Bank of England reduce the interest rate to 0.5% during the recession?

Answer 7

To discourage saving and increase the marginal propensity to consume

Question 8

The inflation rate is at 3%. What might the Bank of England do in order to reduce it?

Answer 8

Increase the base interest rate to decrease consumption and aggregate demand

Question 9

An increase in the base interest rate could lead to…

Answer 9

An increase in the base interest rate may increase consumption for pensioners as they are receiving higher returns on their savings. However, an increase in consumption will shift AD out which may lead to demand-pull inflation, not deflation.

Question 10

The interest rate is often called…

Answer 10

The interest rate is often called the price of borrowing money.

Question 11

A reduction in the interest rate reduces the cost of getting a mortgage. What is the likely effect of this?

Answer 11

Cheaper mortgages mean that more people will be willing and able to take out a mortgage. This allows them to buy a house and so demand for houses will increase which will shift the demand curve to the right and increase house prices.

Question 12

As the value of an individual’s assets increase, they will consume more. This will increase aggregate demand and lead to economic growth. What is this process called?

Answer 12

The positive wealth effect occurs when an increase in the value of an individual’s assets causes them to increase consumption and leads to an increase in AD.

Question 13

What is the wealth effect in most European countries?

Answer 13

Lots of people in European countries rent their home rather than buying it. An increase in house prices makes people who rent feel poorer and they consume less in order to try and save more for the higher house prices. This negative wealth effect balances out the positive wealth effect and so the overall effect is neutral.

Question 14

Explain the impact of a lower interest rate for mortgages on aggregate demand.

Answer 14

A reduction in the interest rate makes mortgages more affordable, because less interest has to repaid on a mortgage. Cheaper mortgages enable more consumers to buy houses, which will increase the demand for houses. This will increase the price of houses and leads to the positive wealth effect. The positive wealth effect is where people increase their consumption as a result of an increase in the value of their assets. Consumption is 65% of AD so an increase in consumption will increase aggregate demand.

However, Richard Sousa has shown that the positive wealth effect is non-existent in many European countries. This is because a lot of people do not own their own houses and are saving up for a house. As a result, an increase in house prices will actually make them feel poorer and force them to save even more. This will reduce consumption. Consumption is 65% of AD so a decrease in consumption will decrease aggregate demand.

Question 15

Explain the impact of a higher base interest rate for mortgages on aggregate demand.

Answer 15

An increase in the base interest rate makes mortgages less affordable, which will decrease the demand for houses. This will decrease the price of houses, leading to the negative wealth effect. The negative wealth effect is where people decrease their consumption as a result of a decrease in the value of their assets. This will decrease aggregate demand.

However, Richard Sousa has shown that the negative wealth effect is non-existent in many European countries. This is because a lot of people do not own their own houses, and so a decrease in house prices will actually make them feel richer. This will increase consumption and aggregate demand.

Question 16

Which of these groups of people might be more negatively impacted by a reduction in the base interest rate?

Answer 16

Pensioners rely on savings as part of their income. A reduction in the base interest rate will reduce the return on savings. This means that pensioners have less disposable income. They will spend less and this will reduce consumption, which is a component of aggregate demand. The AD curve will shift to the left and there will be a fall in real GDP.

Question 17

What impact will a reduction in the base interest rate have?

Answer 17

A reduction in the base interest rate will decrease the cost of borrowing and this will reduce the total amount of money that the person borrowing will have to pay back.

Question 18

Explain the likely impact of a decrease in the base interest rate on investment.

Answer 18

A decrease in the interest rate means that borrowing is cheaper and so investment is likely to increase. This will shift AD out, because investment is a component of AD. Investment will also increase the productivity of the factors of production, which will shift the LRAS out. Both of these will increase real GDP and lead to economic growth.

However, if aggregate demand and animal spirits are particularly low, firms might be concerned that investment will be wasted. This could mean that they do not make a profit on the investment, leaving them unable to pay it back and therefore in debt. So, a decrease in the interest rate might not actually increase investment and economic growth.

Question 19

Which of the following shows a likely impact of an increase in the cost of loan repayments?

Answer 19

D Left shift of short run aggregate supply curve
there has been a change in the costs, which affects short run aggregate supply. An increase in costs will shift SRAS to the left.

Question 20

Explain the likely impact of an increase in the base interest rate on investment.

Answer 20

An increase in the interest rate means that borrowing is more expensive and so investment is likely to decrease. This will shift AD in because investment is a component of AD. Investment will also decrease the productivity of the factors of production, which will shift the LRAS in. Both of these will decrease real GDP and lead to a reduction in economic growth.

However, an increase in loan repayments will increase costs for firms. This will shift SRAS in and force firms to increase their prices. This will increase inflation, which goes against the aims of contractionary monetary policy

Question 21

Will contractionary monetary policy increase or decrease the return from saving?

Answer 21

Contractionary monetary policy involves an increase in the interest rate which will increase the return from saving.

Question 22

An increase in the demand for the pound will cause the exchange rate to…

Answer 22

appreciate

Question 23

Which of the following shows an impact of the Bank of England increasing the base interest rate?

Answer 23

An increase in the interest rate will cause an increase in the demand for the pound from foreign investors. This will then lead to an appreciation of the pound

Question 24

Which of the following is likely to occur if the Bank of England decreases the base interest rate?

Answer 24

If the interest rate in the UK falls, the return on savings will decrease. This means foreign investors will want to hold their money in other countries and so they will sell their pounds in order to buy other currencies

Question 25

Which of the following might be an explanation for a reduction in the interest rate not increasing aggregate demand?

Answer 25

If there are low animal spirits, firms might be worried that new investments could go to waste. If they borrow and invest, and consumption doesn’t increase, then they won’t be able to repay their loans and will go bankrupt. This could be a reason why investment (and therefore AD) won’t increase following a reduction in the interest rate.

Question 26

Which of the following is an appropriate policy for the Bank of England to pursue during a recession?

Answer 26

During a recession, we want to increase AD and expand the economy and so the Bank of England will decrease the base interest rate.

Question 27

Which of the following shows a likely effect of an increase in bank lending?

Answer 27

If banks have more money to lend out then consumers will increase their borrowing. This means that they can increase their spending, which will increase consumption. Similarly, firms can borrow more easily and so investment will increase. Both of these will increase AD.

Question 28

quantitative easing

Answer 28

When the central bank purchases financial assets from banks, increasing the banks’ supply of money and increasing lending to consumers and firms. This increases consumption and investment, shifting out AD.

Question 29

Disadvantage of QE

Answer 29

However, the increase in the money supply may cause an increase in the price level. High inflation could become hyperinflation.

Question 30

The US government enabled the Wall Street Crash to turn into the Great Depression because

Answer 30

1. introduced restrictive policies which increased the price of imports and caused the collapse of world trade .
2. it engaged in a policy of contractionary fiscal policy because of a belief in balanced budgets.
3. it increased interest rates to protect itself from negative consequences of belonging to the gold standard .