Monetary Policy rules

Question 1

How does monetary policy work?

Answer 1

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.

Question 2

1 Aim of monetary policy

Answer 2

Low inflation. UK target is CPI 2% +/-1. Low inflation is considered an important factor in enabling higher investment in the long-term.

Question 3

2 Aim of monetary policy

Answer 3

Stable economic growth. Monetary policy is also concerned with maintaining a sustainable rate of economic growth and keeping unemployment low

Question 4

Moetary policy diagram

Answer 4

Question 5

1 How monetary policy works

Answer 5

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

Question 6

2 How monetary policy works

Answer 6

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

Question 7

How does the BOE set the interest rate?

Answer 7

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

Question 8

After studying these stats what does the BOE do?

Answer 8

From these statistics, the Bank of England decides whether inflation is likely to rise or fall.

Question 9

If the BOE expects higher inflation and higher growth, how will they change interest rates?

Answer 9

they will tend to increase interest rates.

Question 10

If the BOE expects lower inflation and lower growth, how will they change interest rates?

Answer 10

they will tend to cut interest rates.

Question 11

Graphically depict the Impact of expansionary monetary policy to increase AD aka Loose monetary policy

Answer 11

Question 12

Graphically depict the impact of a contractionary monetary policy on AD

Answer 12

Question 13

Why has the BOE kept base rates a record low levels since 2008?

Answer 13

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.

Question 14

How did the financial crisis effect interest rates in 08/09?

Answer 14

In 2008/09, the economy went into deep recession. This led the Bank of England to cut interest rates from 5% to 0.5%

Question 15

1 Limitations of monetary policy

Answer 15

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.

Question 16

2 Limitations of monetary policy

Answer 16

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.

Question 17

3 Limitations of monetary policy

Answer 17

Changing interest rates affects the exchange rate. Tight monetary policy causes an appreciation in the exchange rate which will make exports less competitive.

Question 18

4 Limitations of monetary policy

Answer 18

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

Question 19

5 Limitations of monetary policy

Answer 19

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