Topic 4.1 Monetary Policy Flashcards
Monetary policy
The manipulation of interest rates, the money supply (quantatative easing), credit and exchange rates performed by a country’s central bank in order to influence AD.
Expansionary Monetary Policy
These policies try to increase AD by decreasing interest rates. Aims:
1) Increase inflation
2) Increase growth
3) Decrease unemployment
Shown on a AD/LRAS graph with AD shifting to the right.
Contractionary Monetary Policy
These policies try to decrease AD by increasing interest rates. Aims:
1) Reduce inflation
2) Decrease growth
3) Increase unemployment (cyclical unemployment)
Shown on an AD/LRAS graph with AD shifting to the right.
Central Bank Mandate
To meet inflation targets (set by the government). But also concerned about the general macroeconomic performance of a country
The MPC
This is the monetary policy committee (MPC)
- Their responsibility is setting interest rates
- Independent from the government (part of the BofE) which should give it more credibility
Expansionary Monetary Policy Transmission Mechanism
The main factor is a decrease in interest rates. The following effects:
1) Decreases credit card borrowing (therefore increase in consumption)
2) Less interest added on savings/deposits in the bank (this increases MPC whilst decreases MPS thus increasing consumption)
3) Less interest paid on variable rate mortgages (increases disposable income thus increasing consumption)
4) Decreases interest rates on business loans (incentivises businesses to invest)
5) Weaker exchange rate (increases current account surplus)
Interest rates and the exchange rate
1) Expansionary monetary policy causes demand-pull inflation which means that the £ becomes less valuable thus decreasing the exchange rate so exports are more attractive
2) Hot money outflow. During expansionary monetary policy, investors with large sums of money will seek to deposit their money into alternative bank accounts in foreign countries as they generate less of a return in the current country. This means that they sell their £s and this influx in the supply of £s makes it less valuable thus worsening the exchange rate.
Hot money
International funds move around the world chasing the best interest rates
Expansionary policy and LRAS
Due to factor 4: a decrease in interest rates incentivises businesses to invest, this leads to LRAS shifting to the right as the quantity/quality of FOP increases.
Liquidity trap
This is a con of expansionary policy. It is a Keynesian concept where interest rates have a lower bound which means a cut in interest rates loses their effectiveness after a certain point (the liquidity trap). When interest rates have hit their lower bound, firms and consumers have already converted their more non-liquid assets into more liquid assets (cash) to facilitate spending, investment or wary of banks. Therefore, if the central bank tries to cut interest rates further, it won’t be effective as you already have loads of money; therefore you won’t borrow so you won’t see a further increase in C + I.
Cons of expansionary policy
1) Demand-pull inflation (can overshoot the inflation target)
2) Current account deficit (real incomes are increasing thus an increase in imports)
3) Liquidity trap
4) Negative impact on savers (no longer suitable to save + risk of economic shock means no savings to fall back on)
5) Time lags (it takes time for the interest rates to feed through the transmission mechanism - the BofE say interest rate cuts take 18 months to 2 years to fully feed through to the economy and have the intended effect).
Evaluation of the effectiveness of Monetary Policy
1) Size of the output gap (a very small negative output gap means if the AD curve is already very close to YFE, there will be a large increase in price but less increase in Y. Vice versa for large -ve gap)
2) Consumer confidence (if not confident about job security 0 future state of the economy, they won’t have incentive)
3) Business confidence (have to be confident in order to incentivise business investment)
4) Banks willingness to spend/pass on the full cut (not willing to lend if financial crisis)
5) Size of the rate cut (interest rates should be cut significantly).
Discouraging household and corporate debts
This is a contractionary monetary policy - this is because there’s a concern that when interest rates are very low and there is lots of debt but if the individuals/businesses can’t pay it off due to their own circumstances - it may lead to banks being insolvent and since banks are very interdependent it can lead to a banking crisis (systemic risk) thus a very likely recession. So discouraging it lowers the risk + lowers the pressure on banks
More Sustainable borrowing/lending
This is a pro to contractionary policy. This describes that when interest rates were low, the money borrowed could be borrowed from anyone (with low credit ratings and unlikely to pay it back). This means that economic growth (the increase in consumption) is built on unsustainable borrowing. This causes bubbles (things unsustainable) to be formed such as credit bubbles or asset bubbles and once these bubbles burst (since they are unsustainable) you get guaranteed recessions in the economy.
Pros to contractionary policy
1) Decrease in inflation (demand pull inflation)
2) Discourages household and corporate debts
3) More sustainable borrowing/lending
4) Encourage saving
5) Flexibility for expansionary monetary policy (you now have space for interest rate cuts in the next recession which you can use)
Cons to contractionary monetary policy
1) Lower Growth
2) Higher unemployment
Demand shock of interest rates causing 1 and 2: Central banks try to minimise these trade-offs
3) Impact on indebted (harder to pay back loans)
4) Reduce investment (major LRAS determinant)
5) Can worsen the current account deficit (hot money inflows)
