Monetary Policy (incl. Interest Rates and Monetary Transmission)

Question 1

Define liquidity?

Answer 1

A bank has sufficient reserves to meet demand for deposit withdrawls

Question 2

Define solvency?

Answer 2

The value of a banks assets exceeds the bank’s fixed liabilities

Question 3

What happens when a bank loans to an individual?

Answer 3

IMPORTANTLY - bank has replaced deposit assets with loan assets

1. Bank increase amount of deposits in individuals account - so for bank increase in liabilities, and for individual and increase in assets
2. Banks are entitled to repayments from the individual in the future (loan asset)
3. The loan asset for the bank is a loan liability for the individual

Question 4

What are the pros and cons to banks for lending?

Answer 4

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

Question 5

What happens to broad money (bank money) if base money (central bank issued) increases?

Answer 5

A. Broad money will increase if the open market operation increases the incentives for private banks to lend to their customers

1. Central bank buys loan assets from private banks
2. Increases central bank assets
3. Central bank creates deposit liabilities, and credits them to private bank
4. So private bank loan assets decrease and deposit assets increase, for central bank it is the opposite
5. There is an increase in the supply of base money - broad money will increase if

Question 6

What effect does a decrease in the policy rate have on the broad money supply?

Answer 6

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

Question 7

What is the money multiplier?

Answer 7

When banks are constrained by limited reserves, then increasing supply of reserves will increase lending and broad money

Question 8

What is the effect of a decrease in interest rates for borrowers?

Answer 8

Increases consumption

Question 9

What are the effects of a decrease in the interest rate on savers? (income and sub effects)

Answer 9

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

Question 10

What is the main instrument for monetary policy?

Answer 10

Bank rate (interest rates)

Question 11

What is the main target for monetary policy?

Answer 11

The inflation rate

Question 12

What are the four monetary policy transmission mechanisms intermediate targets?

Answer 12

1. market interest rates
2. asset prices
3. expectations/confidence
4. exchange rate

Question 13

What happens to asset prices when interest rates fall?

Answer 13

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

Question 14

Explain the income and substitution effect of a fall in the interest rate on asset prices/consumption?

Answer 14

Income effect - increase in household wealth of asset-owning households increases consumption

Substitution - increases consumption

Question 15

What effect will a fall in interest rates have for banks?

Answer 15

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

Question 16

What is the effect of a decrease in interest rates in the UK on aggregate demand/inflation?

Answer 16

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)

Question 17

What is the zero lower bound on policy interest rates?

Answer 17

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

Question 18

What can an issue with monetary policy be?

Answer 18

Disrupted interest rate pass through - from policy rate to market rate

Question 19

What is quantitative easing?

Answer 19

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

Question 20

Why is the central bank independent from the government?

Answer 20

Elected govts attempt to exploit Phillips curve trade-off in advance of elections

Question 21

The is the Bank of England goal independent/dependent? What about policy?

Answer 21

Goal dependent - targets of monetary policy are set by Parliament
Policy independent - BoE sets its policy rate independent of govt and parliament

Question 22

What do central banks want to do with employment and inflation when policy rate setting?

Answer 22

Maintain employment and the labour market equilibrium
Maintain Phillips curve at a level where equilibrium employment is consistent with the inflation target

Question 23

What are the limitations of monetary policy?

Answer 23

1. Liquidity trap
2. Difficult to control many objectives with one tool
3. Higher interest rates can appreciate the exchange rate which will reduce the competitiveness of exports
4. Interest rates affect different parts of the economy more than others e.g. homeowners
5. Time lags
6. Risk of hyperinflation

Question 24

What is a liquidity trap?

Answer 24

When monetary policy becomes ineffective because despite zero/very low interest dates people want to hold cash rather than spend or buy illiquid assets

Question 25

What are the pros of monetary policy?

Answer 25

1. Stabilize the economic cycle and avoid recessions
2. Keep inflation low
3. In normal conditions, very effective on altering household spending
4. Set independent from govt so no political interference
5. Can be adjusted regularly - more regularly than fiscal policy

Question 26

What are the benefits of inflation targeting? (4)

Answer 26

1. Avoid boom and bust
2. 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
3. Benefits of low inflation e.g. higher investment, higher savings value and more internationally competitive
4. Clarity

Question 27

What are the problems of inflation targeting? (6)

Answer 27

1. Cost-push inflation may cause a temporary increase inflation
2. Central banks ignore other problems e.g. unemployment
3. Sometimes high inflation is needed e.g. in a liquidity trap
4. Inflation targets are limited
5. A large output gap doesn’t necessarily lead to deflation
6. What inflation measure should be used?

Question 28

How does inflation targeting work?

Answer 28

Govt sets inflation target, central bank uses monetary policy to try to meet target

Question 29

Explain how an increase in the policy rate impacts inflation through the market rate?

Answer 29

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

Question 30

Explain how a decrease in the policy rate impacts inflation through asset prices?

Answer 30

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

Question 31

Explain how an increase in the policy rate impacts inflation through the exchange rate?

Answer 31

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

Question 32

What is the Taylor Rule?

Answer 32

formula tying a central bank’s policy rate to inflation and economic growth

Question 33

For policy to be effective, what must it be?

Answer 33

Credible

Question 34

What is time inconsistency?

Answer 34

Policies that may be optimal today may not be optimal later on once agents have adjusted their expectations