monetary policy transmission mechanisms Flashcards
Monetary Policy Actions
interest rates
exchange rates
money supply
forward guidance
Monetary Policy Actions - interest rates
Tool for influencing borrowing, spending, and investment in the economy
Adjusted by central banks through changes in the bank rate
Lower rates stimulate economic activity; higher rates can cool down an overheating economy
monetary policy actions - exchange rates
Reflect the value of one currency relative to another
Central banks can influence exchange rates by buying or selling currencies
Weaker currency boosts exports; stronger currency can control inflation but may increase imports
monetary policy actions - Money Supply
Total amount of money circulating in an economy
Controlled by central banks through open market operations such as using the required reserve requirements or quantitative easing
Crucial for managing inflation, interest rates, and overall economic stability
monetary policy actions - forward guidance
Communication tool used by central banks to provide insight into future monetary policy intentions
Aims to influence market expectations by signalling likely future actions regarding interest rates, inflation targets, or other policy measures
Helps guide economic behaviour by managing expectations about future monetary policy actions
factors to consider when settling the bank rate - economic expansion - macroeconomic effects-impact on setting bank rate
macroeconomic effects -An economic expansion is associated with high levels of economic growth and low levels of unemployment
This increases AD and causes inflationary pressures
impact on setting bank rate -Historically, when the economy was overheating, the Central Bank increased interest rates. This is known as a contractionary monetary policy
During recent periods of high inflation, interest rates have decreased or remained unchanged. This is because adjustments also consider economic growth forecasts and geopolitical uncertainty
factors to consider when settling the bank rate - economic contraction - macroeconomic effects-impact on setting bank rate
macroeconomic effects - An economic contraction is associated with a recession and low levels of unemployment
This decreases AD and causes deflationary pressures
impact on setting bank rate - Historically, when the economy is contracting, the bank has decreased its interest rate. This is known as an expansionary monetary policy
This may not always be possible, as other variables, such as high house prices, may impact interest rate adjustment
what are the two main instruments of monetary policy ?
incremental adjustments - Incremental adjustments to the interest rate (usually not more than 0.25%)
quantitative easing - (occurs when the central bank purchases securities (bonds) on the open market so as to increase the money supply )
what is transmission mechanism
When a policy decision is made, it creates a ripple effect through the economy and this effect is known as a transmission mechanism
official rates
the base rate of interest set by the Bank of Englands monetary policy committee
market rates
the interest rates set by the commercial banks for their customers (savings and loans )
asset prices
an asset is a good / resource that can provide future economic benefits
exchange rates
a relative price of one currency expressed in terms of another currency
net external demand
the demand for a country’s exports
inflation
increases in price over a given period of time
what is the transmission impact on exchange rates ?
A change to the bank rate will have an impact on the exchange rate
When the exchange rate changes, there will be a ripple effect through the economy
what is the impact of a decrease in interest rates ?
A decrease in UK interest rates is less attractive for investors
This causes capital flight as investors move their money out of the country
As a result, the demand for the pound decreases, causing the exchange rate to fall
UK exports will become relatively cheaper due to a weaker exchange rate
Therefore, the initial rise in value of the pound may be mitigated by an increase in export sales
This increase in demand is dependent on price elasticity of demand of exports
what is the impact of an increase in interest rates ?
An increase in UK interest rates is more attractive for investors
This causes capital inflow as investors move their money into the country
As a result, the demand for the pound increases, causing the exchange rate to rise
UK exports become relatively more expensive due to a stronger exchange rate
Therefore, the initial fall in value of the pound may be mitigated by a decrease in export sales
This increase in demand is dependent on price elasticity of demand of exports
what happens if inflation is too high and we increase interest rates?
If the MPC wants to lower inflation, it will increase the interest rate
This lower rate aims to reduce aggregate demand and control inflation
Contractionary monetary policy will shift aggregate demand to the left
The Bank of England cut the Bank Rate nine times between December 2007 & March 2009 dropping from 5.75% to 0.5%
draw Keynesian contractinary demand side policy
diagram analysis
Contractionary monetary policy will shift aggregate demand to the left (AD1 →AD2)
AD shifts to the left because a higher interest rate impacts the components: Consumption (C ), Investment (I) and Exports and Imports (X − M) via the exchange rate
Consumption
With the rise in interest rates, consumption declines as household borrowing is discouraged and savings are encouraged (C)
The increase in interest rates on mortgages results in decreased disposable income for households
Consumers now have less income and tend to spend less, leading to a notable decrease in aggregate demand (AD1 →AD2)
This fall in aggregate demand contributes to a reduction in real GDP (YFE → Y1) and average price levels (AP1 → AP2)
Investment
Investment falls as businesses borrow less due to higher interest rates
Higher borrowing costs serve as a disincentive for businesses to undertake new investment projects
This reduction in business investment leads to a decline in aggregate demand in the UK economy (AD1 →AD2)
The contraction in aggregate demand results in a reduction in real GDP from its potential level (YFE) to a lower level (Y1)
Additionally, the weakened demand contributes to a decrease in average price levels, transitioning from AP1 → AP2
Net Exports
A higher interest rate increases demand for the UK pound, as it offers a better return on investment, increasing capital flows into the currency
The increased demand for the pound causes the exchange rate to rise. As a result:
Exports become relatively more expensive and less competitive in the global market
Imports become relatively cheaper and more competitive in the UK markets.
This worsens the UK’s Balance of Payment on the current account.
Aggregate Demand (AD) shifts to the left as a result of these economic changes, reflecting reduced overall spending in the economy
what happens if inflation is too low and we decrease interest rates ?
If the MPC wants to encourage borrowing, it will decrease the interest rate
This lower rate aims to stimulate aggregate demand
This type of policy is known as a demand-side expansionary policy
draw expansionary demand side policies diagram
diagram analysis
Increase in real GDP (Y1 →Y2) and average price levels (AP1 →AP2)
Expansionary Monetary Policy will shift aggregate demand to the right (AD2 → AD1):
AD Shifts to the right because lower Interest Rates Impact the Components: Consumption (C), Investment (I), and Exports and Imports (X − M) via the Exchange Rate:
Consumption
Lower interest rates stimulate consumption as households have more disposable income.
Increased consumer spending contributes to a rise in aggregate demand (AD2 → AD1)
This increase in aggregate demand leads to an expansion in real GDP (Y1 → YFE) and average price levels (AP2 → AP1)
Investment
Lower interest rates make borrowing more attractive for businesses, encouraging new investment projects
The increase in business investment contributes to an increase in aggregate demand (AD2 → AD1)
This expansion in aggregate demand results in an increase in real GDP from its potential level (YFE) to a higher level (Y1)
Additionally, the heightened demand contributes to an increase in average price levels, transitioning from (AP2 → AP1)
Net Exports
A lower interest rate reduces demand for the UK pound, as it offers a lower return on investment, leading to decreased capital flows into the currency
The decreased demand for the pound causes the exchange rate to fall. As a result:
Exports become relatively cheaper and more competitive in the global market.
Imports become relatively more expensive and less competitive in the UK markets.
This improves the UK’s Balance of Payment on the current account
Aggregate Demand (AD) shifts to the right as a result of these economic changes, reflecting increased overall spending in the economy (AD2 → AD1)
