Monetary Policy rules Flashcards
How does monetary policy work?
Monetary policy involves using interest rates and other monetary tools to influence the levels of consumer spending and aggregate demand (AD). In particular monetary policy aims to stabilise the economic cycle – keep inflation low and avoid recessions.
1 Aim of monetary policy
Low inflation. UK target is CPI 2% +/-1. Low inflation is considered an important factor in enabling higher investment in the long-term.
2 Aim of monetary policy
Stable economic growth. Monetary policy is also concerned with maintaining a sustainable rate of economic growth and keeping unemployment low
Moetary policy diagram
1 How monetary policy works
UK monetary policy is set by the Monetary Policy Committee (MPC) of the Bank of England.
They are independent in setting interest rates but have to try and meet the government’s inflation target
2 How monetary policy works
The Bank of England set the base rate. This is the rate commercial banks borrow from the Bank of England.
Changing the base rate tends to influence all interest rates in the economy – from saving rates to mortgage and lending rates
How does the BOE set the interest rate?
The Bank of England studies inflationary trends in the economy. This involves looking at a range of economic variables such as:
Unemployment, consumer confidence, spare capacity in the economy, exchange rate index, house prices, economic growth
After studying these stats what does the BOE do?
From these statistics, the Bank of England decides whether inflation is likely to rise or fall.
If the BOE expects higher inflation and higher growth, how will they change interest rates?
they will tend to increase interest rates.
If the BOE expects lower inflation and lower growth, how will they change interest rates?
they will tend to cut interest rates.
Graphically depict the Impact of expansionary monetary policy to increase AD aka Loose monetary policy
Graphically depict the impact of a contractionary monetary policy on AD
Why has the BOE kept base rates a record low levels since 2008?
Since the financial crisis of 2009, economic growth has been sluggish and inflationary pressures low. Therefore, the Bank of England has kept interest rates at record low levels.
How did the financial crisis effect interest rates in 08/09?
In 2008/09, the economy went into deep recession. This led the Bank of England to cut interest rates from 5% to 0.5%
1 Limitations of monetary policy
Liquidity Trap – This occurs when a cut in interest rates fail to stimulate economic activity. e.g. because of low confidence or banks don’t want to pass base rate cut onto consumers.
2 Limitations of monetary policy
Difficult to control many objectives with one tool – interest rates. For example, a rise in oil prices causes cost-push inflation and lower growth. The Bank could increase interest rates to reduce inflation, but, it would cause economic growth to fall as well. In 2009, inflation rose to rising oil prices, but the economy was also in recession; the Bank decided to ‘allow’ the temporary inflation and concentrate on economic recovery.
3 Limitations of monetary policy
Changing interest rates affects the exchange rate. Tight monetary policy causes an appreciation in the exchange rate which will make exports less competitive.
4 Limitations of monetary policy
Interest rates may affect some parts of the economy more than others. e.g. higher interest rates increase the disposable income of people with savings. But, could cause homeowners to be unable to afford their mortgages
5 Limitations of monetary policy
Time lags – If the Bank of England change base rates, it can take up to 18 months for the effects to filter through the economy. For example, if people have a two-year fixed mortgage, they will not notice until they remortgage. This means the Bank needs to predict future inflation so that they can change interest rates in anticipation
