Monetary Policy

Question 1

Examples of Central Banks

Answer 1

-Bank of England

-Federal reserve (USA)

-Central European Bank

Question 2

Info about central banks

Answer 2

Lenders of last resort

They are independent of government

Responsible for managing monetary policy for that currency

Question 3

Aims of central banks

Answer 3

To maintain financial stability

Helps the government to maintain economic stability

Question 4

Definition of a central bank

Answer 4

The bank of an economy responsible for the issue of money and management of monetary policy for that currency

Question 5

What is monetary policy

Answer 5

The manipulation of the price and availability of money within an economy to achieve economic policy objectives

Question 6

Main focus of central banks and monetary policy

Answer 6

The level of interest rates set in an economy

Question 7

Other factors central banks and monetary policy focus on

Answer 7

Influencing the size of the money supply

Availability of credit i.e. money that can be borrowed by consumers and businesses

Exchange rate

Quantitative easing

Question 8

Since 1997, the Bank of England ….

Answer 8

has been largely free of government when setting monetary policy

However they still have influence as it sets targets for the BoE to achieve.

Question 9

Who sets the interest rates monthly

Answer 9

The monetary policy committee of the BoE

Question 10

Areas of consideration when setting interest rates

Answer 10

Consumer spending and confidence

Business investment and confidence

Fiscal Policy - government expenditure and taxation

Exchange rate

Commodity prices

Unemployment and labour market conditions

House prices

GDP growth

Question 11

Purpose of expansionary monetary policy

Answer 11

To boost AD

Question 12

Purpose of contractionary monetary policy

Answer 12

To reduce AD

Question 13

Interest rates definition

Answer 13

Cost of borrowing, reward for saving

The BoE sets policy interest rates with the need to meet an inflation target of consumer price inflation of 2%

Question 14

Chain of analysis linking Consumer confidence and Demand Pull inflation

Answer 14

Consumer confidence = Consumption = Component of AD = AD shifts = Demand Pull inflation

Question 15

Chain of analysis linking business confidence and DP Inflation

Answer 15

Business Confidence = Investment = Component of AD = AD shifts = DP Inflation

Question 16

Chain of analysis linking Fiscal Policy and Demand pull Inflation

Answer 16

Fiscal Policy = Govt spending/ Consumption/ Investment = Component of AD shifts = AD shifts = Demand-pull inflation

Question 17

Chain of analysis linking unemployment and DP Inflation

Answer 17

Unemployment reducing = Consumer spending = Consumption = Component of AD shifts= AD shift = DP inflation

Question 18

Chain of analysis for Commodity prices rising and Cost-push inflation

Answer 18

Commodity prices rising = Costs of Production = SRAS Shifts = Cost Push Inflation

Vice Versa = Deflation

Question 19

Forms of Interest

Answer 19

Credit Cards/ Current accounts/ mortgage/ savings/ gilts/ corporate bonds/ mortgage

Question 20

High Interest rates impact on saving and borrowing

and low interest rates impact

Answer 20

Saving increases borrowing decreases

Low interest rates - savings decrease borrowing increases

Question 21

Interest rates impact on Investment and House Prices

Answer 21

High IR = Decreased investment, and reduced house prices

Low IR = Investment increases and house prices rise

Question 22

Why does High IR reduce house prices

Answer 22

Even tho it makes mortgage repayments more expensive, house prices are determined by supply and demand and function in the market mechanism

Question 23

What is the Transmission Mechanism

Answer 23

The process through which changes in monetary policy, particularly changes in the base rate set by the central bank, affect AD and inflation in the economy.

Question 24

First stage of transmission mechanism

Answer 24

Official rate

Question 25

Second stage of transmission mechanism

Answer 25

Market rates Asset Prices Expectations/Confidence Exchange Rates

Question 26

Third stage of transmission mechanism

Answer 26

Domestic Demand External Demand = Total Demand

Question 27

Last stage of transmission mechanism

Answer 27

Domestic inflationary pressure Import prices affected = Inflation

Question 28

Chain of analysis examples for when Interest Rates Rise linking to falling inflationary pressure

Answer 28

IR rises = More expensive to borrow = less incentive to borrow = falling consumer spending = AD falls = less inflationary pressure IR rises = More reward for saving = More incentive to save = falling consumer spending = falling AD = Falling inflationary pressure IR rises = Rates rise on variable rate of mortgages = Less discretionary income = Consumer spending falls = Falling AD = Falling inflation pressure

Question 29

Step through hot money flows

Answer 29

Interest rates rise = Attracts inwards hot money flows = Demand for the currency rises on the forex market = Value of currency rises = Exports become more expensive and imports cheaper = Demand for X falls, Net trade decreases = AD and inflationary pressure falls

Question 30

Hot Money Outflows chain of analysis

Answer 30

Interest rates fall = No attraction for money to be held in UK accounts = Demand for the currency on forex market Falls = Value of currency falls = Imports dearer and exports cheaper = Net trade increases = AD shifts = Increased inflationary pressure

Question 31

Positive consequences of IR rising

Answer 31

-Increased reward for saving -Control inflation -Stronger Currency -Can decrease import prices -Reduces asset price bubbles

Question 32

Negative consequences of IR rising

Answer 32

X becomes dearer as a result of hot money flows Reduced C and I = AD falls higher unemployment risk if firms cut back on investment + consumers spend less -risk of recession if cut harshly -Inequality effects as savings benefit wealthier more -Lower tax revenue -Cost-push or demand pull inflation

Question 33

Chain of analysis how Monetary policy can cause cost push inflation

Answer 33

Expansionary Monetary Policy leads to Increased Aggregate Demand -higher AD = increased demand for labour -workers gain higher bargaining power and start demanding higher nominal wages rising wages causing costs of production to increase Firms raise prices to continue profit margins = cost-push inflation

Question 34

Limitations of interest rates in controlling economy ‘depends on’ evaluation

Answer 34

-The size of the change in rates - Can cause inflation if cut too harshly -The level of confidence within the economy -The level of economic activity -What is happening with fiscal policy -Level of economic development -Credibility of the central bank

Question 35

Evaluation of monetary policy and why it sometimes doesn’t work

Answer 35

-Time lags in their effectiveness -uncertain effects -When IR are low, further cuts may be unavailable -Effects on SRAS are less significant and less certain in terms of size of impact

Question 36

Define Quantitative easing

Answer 36

An unconventional form of monetary policy that involves the introduction of new money into the national supply,the process involves controlling interest rates and boosting AD, usually by a central bank buying assets such as bonds

Question 37

Chain of analysis how QE can impact economy

Answer 37

New electronic money created by the central bank = Used to buy assets from financial institutions such as bonds = Price of the bonds increases = Causes bond yield to fall = Financial institutions sell bonds and have more liquidity = More liquidity is an incentive for financial institutions to lend more = Lower yields mean lower IR = cheaper credit so Investment and Consumption rise = AD rises

Question 38

Other ways QE can impact economy

Answer 38

Decreasing the interest rates not only will increase AD but leads to a depreciating currency so net trade increases Bond and asset prices going up creates a positive wealth effect