Monetary Policy (incl. Interest Rates and Monetary Transmission) Flashcards
Define liquidity?
A bank has sufficient reserves to meet demand for deposit withdrawls
Define solvency?
The value of a banks assets exceeds the bank’s fixed liabilities
What happens when a bank loans to an individual?
IMPORTANTLY - bank has replaced deposit assets with loan assets
- Bank increase amount of deposits in individuals account - so for bank increase in liabilities, and for individual and increase in assets
- Banks are entitled to repayments from the individual in the future (loan asset)
- The loan asset for the bank is a loan liability for the individual
What are the pros and cons to banks for lending?
Pro - loan may pay higher interest than deposits and bank of England
Cons - with fewer deposits, the bank increases illiquidity risk
- loan assets are more risky than deposit assets, so increase their insolvency risk
What happens to broad money (bank money) if base money (central bank issued) increases?
A. Broad money will increase if the open market operation increases the incentives for private banks to lend to their customers
- Central bank buys loan assets from private banks
- Increases central bank assets
- Central bank creates deposit liabilities, and credits them to private bank
- So private bank loan assets decrease and deposit assets increase, for central bank it is the opposite
- There is an increase in the supply of base money - broad money will increase if
What effect does a decrease in the policy rate have on the broad money supply?
Decrease in policy rate -> reduces interest accruing to private banks’ deposits held at the central bank AND reduces the interest cost of short term loans from central bank -> increase in incentives to lend and so increase in broad money supply
What is the money multiplier?
When banks are constrained by limited reserves, then increasing supply of reserves will increase lending and broad money
What is the effect of a decrease in interest rates for borrowers?
Increases consumption
What are the effects of a decrease in the interest rate on savers? (income and sub effects)
Income effect = lower interest rates, savers see a reduce income as they get lower income payments from interest, so increase savings to meet future target income - LOWER CONSUMPTION
Substitution effect = reward from saving falls, so relatively more attractive to INCREASE CONSUMPTION
What is the main instrument for monetary policy?
Bank rate (interest rates)
What is the main target for monetary policy?
The inflation rate
What are the four monetary policy transmission mechanisms intermediate targets?
- market interest rates
- asset prices
- expectations/confidence
- exchange rate
What happens to asset prices when interest rates fall?
Asset prices rise
Can think of as how much would you need to put into a savings account now to withdraw same amount in a year - if interest low need more money so asset price high
Explain the income and substitution effect of a fall in the interest rate on asset prices/consumption?
Income effect - increase in household wealth of asset-owning households increases consumption
Substitution - increases consumption
What effect will a fall in interest rates have for banks?
Banks have long-term assets and short-term liabilities, and so ceteris paribus, a fall in the interest rate will increase the asset value by more than the increase the liability value, and so the equity value of banks will be higher, risk will be lower which will encourage lending
What is the effect of a decrease in interest rates in the UK on aggregate demand/inflation?
Decrease r/i -> decrease demand for £ -> investors look elsewhere for higher returns -> higher prices of imported and exports goods in £ -> increase demand for exporting firms and increasing costs for importing firms -> higher net exports -> higher demand (can lead to higher inflation)
What is the zero lower bound on policy interest rates?
When nominal interest rates fall below zero there is an incentive to hold banknotes instead of negative-interest assets, so nominal interest are bounded below/close to zero as if they are below then monetary policy cannot be used to stabilize the economy
What can an issue with monetary policy be?
Disrupted interest rate pass through - from policy rate to market rate
What is quantitative easing?
Central bank increase base money electronically, and then uses the extra reserves to buy various low-risk securities - used to increase bank lending and increase inflation
Why is the central bank independent from the government?
Elected govts attempt to exploit Phillips curve trade-off in advance of elections
The is the Bank of England goal independent/dependent? What about policy?
Goal dependent - targets of monetary policy are set by Parliament
Policy independent - BoE sets its policy rate independent of govt and parliament
What do central banks want to do with employment and inflation when policy rate setting?
Maintain employment and the labour market equilibrium
Maintain Phillips curve at a level where equilibrium employment is consistent with the inflation target
What are the limitations of monetary policy?
- Liquidity trap
- Difficult to control many objectives with one tool
- Higher interest rates can appreciate the exchange rate which will reduce the competitiveness of exports
- Interest rates affect different parts of the economy more than others e.g. homeowners
- Time lags
- Risk of hyperinflation
What is a liquidity trap?
When monetary policy becomes ineffective because despite zero/very low interest dates people want to hold cash rather than spend or buy illiquid assets
What are the pros of monetary policy?
- Stabilize the economic cycle and avoid recessions
- Keep inflation low
- In normal conditions, very effective on altering household spending
- Set independent from govt so no political interference
- Can be adjusted regularly - more regularly than fiscal policy
What are the benefits of inflation targeting? (4)
- Avoid boom and bust
- Credibility/expectations - if commitment to low inflation is made then tends to have lower inflation expectations so workers don’t demand higher wages and firms tend not to increase prices - self reinforcing cycle
- Benefits of low inflation e.g. higher investment, higher savings value and more internationally competitive
- Clarity
What are the problems of inflation targeting? (6)
- Cost-push inflation may cause a temporary increase inflation
- Central banks ignore other problems e.g. unemployment
- Sometimes high inflation is needed e.g. in a liquidity trap
- Inflation targets are limited
- A large output gap doesn’t necessarily lead to deflation
- What inflation measure should be used?
How does inflation targeting work?
Govt sets inflation target, central bank uses monetary policy to try to meet target
Explain how an increase in the policy rate impacts inflation through the market rate?
Increase in policy rate -> increases market rate -> savings become more attractive AND individuals/firms may have lower disposable income because of higher mortgage/loan repayments AND discourages investment -> lower AD -> lower inflation
Explain how a decrease in the policy rate impacts inflation through asset prices?
Lower interest rates -> increase demand for assets -> increases the price of assets -> makes it easier to borrow AND increases individuals wealth -> increase consumption and investment -> increase AD -> increase inflation
Explain how an increase in the policy rate impacts inflation through the exchange rate?
Increase in interest rate -> better rate of return on investment in UK -> hot money flows in to UK to take advantage of higher interest rates -> increases demand for UK currency -> appreciation in value of currency -> exports become relatively more expensive -> export demand falls -> AD falls -> inflation falls
What is the Taylor Rule?
formula tying a central bank’s policy rate to inflation and economic growth
For policy to be effective, what must it be?
Credible
What is time inconsistency?
Policies that may be optimal today may not be optimal later on once agents have adjusted their expectations
