Monetary Policy

Question 1

What is the Monetary Policy?

Answer 1

• Using interest rates and other monetary tools to influence the levels of consumer spending and aggregate demand (AD).

Question 2

What are the aims of the using the Monetary Policy?

Answer 2

• Stabilise the economic cycle - Keep inflation low - Avoid recessions.

Question 3

What is the inflation aim?

Answer 3

2% (+/- 1%)

Question 4

How does higher interest rates affect inflation?

Answer 4

Reduces demand and lowers inflation

Question 5

How does lower interest rates affect inflation?

Answer 5

Increases consumer spending and investment which could cause a recession.

Question 6

How does the Monetary Policy work?

Answer 6

• 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. - 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 Bank of England set interest rates?

Answer 7

By looking at inflationary trends in the economy.

Question 8

What kind of inflationary trends does the bank of England look at when setting inflationary trends?

Answer 8

• Unemployment - Consumer confidence - Spare capacity in the economy - Exchange rate index - House prices - Economic growth

Question 9

What will the Bank of England do to interest rates if they expect higher inflation and higher growth?

Answer 9

Increase Interest Rates

Question 10

What will the Bank of England do to interest rates if they expect lower inflation and higher growth?

Answer 10

Decrease Interest Rates

Question 11

Why would cutting interest rates stimulate economic activity?

Answer 11

• Reduces borrowing costs - This increases the disposable income of consumers with mortgage interest payments - Encourage spending.

Question 12

What is Loose Monetary Policy?

Answer 12

If inflation is falling below 2% Bank of England will CUT interest rates.

Question 13

What is Tight Monetary Policy?

Answer 13

If the economy is growing too quickly they will increase interest rates to reduce economic growth & inflationary pressures.

Question 14

Diagram showing Loose Monetary Policy?

Answer 14

Question 15

Diagram showing Tight Monetary Policy??

Answer 15

Question 16

Limitations of the Monetary Policy?

Answer 16

• Liquidity Trap – This occurs when a cut in interest rates fail to stimulate economic activity. Because of low confidence or banks don’t want to pass base rate cut onto consumers.
• Difficult to control many objectives with one tool – interest rates.
• Changing interest rates affects the exchange rate.
• 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.