3.6 Monetary policy

Question 1

What is monetary policy?

Answer 1

A policy that aims to control the total supply of money in an economy

Question 2

What does monetary policy use?

Answer 2

it mainly uses interest rates, but also other measures to influence the levels of total demand in the economy

Question 3

What is monetary policies major objective?

Answer 3

its major objective is a low and stable rate of inflation

Question 4

Who operates the UK’s monetary policy?

Answer 4

The Monetary Policy Committee of the Bank of England

Question 5

What is the target inflation rate in the UK?

Answer 5

in the UK, the target is to keep inflation at 2% per annum

Question 6

What does the MPC do if it wants to increase the rate of economic growth and reduce unemployment?

Answer 6

It reduces interest rates because as a result spending in the economy will rise. This extra spending becomes income for firms, which produce more output. These firms may then employ more workers to meet the extra demand, and these workers will also have incomes to spend

Question 7

What does the MPC do if it wants to achieve price stability and a healthier balance of payments?

Answer 7

in increases interest rates because as a result spending in the economy will fall, which means there will be less demand for the output of firms, and in a response they are likely to reduce prices or not increase them, therefore reducing the rate of inflation. the fall in demand brought about by a fall in interest rates, also reduces the demand for imports, thus helping to achieve the objective of a balance in the balance of payments

Question 8

What is another monetary policy the bank of England uses apart from interest rates/

Answer 8

Quantitative easing, where the central bank makes more money available for financial institutions to lend to households and firms

Question 9

How does monetary policy affect growth?

Answer 9

assuming that interest rates fall:

• lower interest rates make the costs of borrowing money cheaper, which may encourage more people to take out loans and buy expensive items such as cars or houses. People may spend their income instead of save it since the reward for saving is low, leading to an increase in total demand. All the spending becomes income for firms, and they may have to employ more workers in order to meet the extra demand, resulting in an increase of output and more workers with incomes.
• The cost of borrowing for firms is also cheaper, which might encourage them to take out loans in order to finance investments and expand.
• disposable incomes rise for households with mortgages since the costs of repaying mortgages has fallen.
• The UK exchange rate will fall since there will be an increase in supply/fall in demand. This means exports are now cheaper, making the UK more competitive, and export sales are likely to rise. This also means imports to the UK are more expensive, so there will be more spending on UK produced goods and services, leading to more output

Question 10

How does monetary policy affect price stability?

Answer 10

Interest rate rise in order to fight inflation resulting in:

• Spending and borrowing by consumers will decrease since the cost of borrowing rises which discourages them from taking out loans to finance their spending.
• saving increases since the reward for saving will increase which gives consumers an incentive to save their money instead of spend it.
• borrowing by firms falls since the costs of borrowing money increase which discourages them from taking out loans in order to finance their investments.
• it becomes less attractive to buy assets such as housing since asset prices fall
• disposable income falls for households with mortgages since the monthly costs of the mortgage repayment rise, as a result this leads to a fall in consumer spending.
• The UK exchange rate rises, which makes imports cheaper and also help reduce inflation since there will be less demand for spending in the UK.

Question 11

How does monetary policy affect employment?

Answer 11

assuming that interest rates fall;

• spending and borrowing by consumers increase, therefore total demand rises. This spending becomes income for firms, which they may then need to employ more workers in order to meet the extra demand, resulting in more employment.
• borrowing for investments by firms increases, which the the business may use on expanding and will then need for workers, resulting in more employment.
• the UK exchange rate falls, which leads to more demand for UK goods and less demand for imports. This means UK firms will need more workers in order to meet the extra demand, resulting in higher employment.

Question 12

What are the effects of monetary policy on consumer spending?

Answer 12

• as interest rates fall, we would expect consumer spending to also rise however, the extent to which it will rise cannot be known in advance. If the interest rates on consumer’s savings account fall by a small percentage, we wouldn’t know how many would stop saving their money and spend more instead.
• On the other hand, a large proportion of UK households have mortgages, so a fall in interest rates will have a bigger impact on consumer spending in the UK compared to other countries with more people who rent instead of buy
• if interest rates were to rise on consumers savings accounts by a small percentage, we cant know how many will deliberately increase their savings and spend less, there may even not be much of an effect on consumer spending even if interest rates rise