3.2 Monetary policy

• Monetary policy:

  The manipulation of the money supply, interest rate, exchange rate and the amount of credit available in order to promote economic stability, economic growth and price stability.
• Expansionary/loosening monetary policy:

  Government policy to decrease the rate of interest/increase money supply in order to stimulate economic activity and increase the rate of inflation.
• Discretionary income:

  Income remaining once tax and essential housing costs, such as mortgage payments, have been paid
• Contractionary/tightening monetary policy:

  Government policy to increase the rate of interest/decrease money supply in order to reduce economic activity and the rate of inflation.
• Quantitative easing:

  A process by which liquidity in the economy is increased when the Bank of England purchases assets from commercial banks
• Hot money:

  Short term, capital flow responding to changes in relative interest rates.
• Liquidity trap:

  When a reduction in the rate of interest no longer stmulates economic stability because there is too much liquidity in the system.
• The effectiveness of monetary policy in achieving the government's macroeconomic objecives depends upon/is limited by:

  1. Time lags 2. Lack of targeting of particular sectors 3. Business and consumer confidence 4. The liquidity trap 5. Monetary policy asymmetry
• Define asymmetric inflation targeting

  when the Central Bank only intervenes when inflation is too high, not when it is too low.
• Define interest rates

  The price of borrowing money
• Define liquidity trap

  When a change in the money supply doesn't change the interest rate which means monetary policy can't be used to influence consumption and investment.
• Define monetary policy

  The attempts of the Central bank to control the level of AD by altering the base interest rates or the amount of money in the economy.
• Define money supply

  Stock of money in the economy
• Define quantitative easing

  When the Central Bank buys assets in exchange for money in an attempt to increase the money supply.
• Define symmetric inflation targeting

  When the Central Bank intervenes when inflation is too high or too low.
• Monetary policy: reducing interest rates effect on AD: consumer spending

  As it's cheaper for consumers to borrow from commercial banks, low-interest rates reduce the opportunity cost of saving. Families with variable-rate mortgages benefit from reduced repayments, which raise disposable income and, as a result, increase the number of mortgages taken out by households, increasing housing demand. Because the supply of housing in the U.k. is PES inelastic, house prices rise proportionately faster. This causes a positive wealth effect, in which individuals spend more because they feel wealthier, hence increasing consumption.
• Monetary policy: reducing interest rates effect on AD: investment

  Low-interest rates mean it is cheaper for firms to borrow from commercial banks, and use these cheap loans to fund R&D or other forms of investment.
• Monetary policy: reducing interest rates effect on AD: government spending

  Low-interest rates mean government debt repayments will be lower and so will encourage the government to issue more bonds to contribute to higher levels of government spending.
• When is qualitative easing used?

  Used by banks to help stimulate the economy when standard monetary policy is no longer effective. i.e interest rates cannot be lowered any further than their current rate. Bank of England electronically creates more money that can be used to buy government and bank bonds.
• Effect of quantitative easing : banks

  Banks will naturally lend more to households and firms now that they have more money, so increasing total demand and stimulating the economy. This assumes, however, that banks would not just sit on the additional cash provided by the BoE, as they may be anxious about their clients' ability to repay loans, as they were during the 2008 Financial Crisis.
• Effect of quantitative easing : government

  The government now has the cash to invest more in the economy, such as in training and education or other types of capital spending in the aim of boosting the economy, due to the Central Bank's purchase of government bonds.
• Limitations of monetary policy: base rate

  Banks might not pass the base rate onto consumers, which means that even if the central bank changes the interest rate, it might not have the intended effect.
• Limitations of monetary policy: banks unwilling to lend

  Even if the cost of borrowing is low, consumers might be unable to borrow because banks are unwilling to lend. After the 2008 financial crisis, banks become more risk-averse.
• Limitations of monetary policy: confidence

  Interest rates will be more effective at stimulating spending and investment when consumer and firm confidence is high. If consumers think the economy is still risky, they are less likely to spend, even if interest rates are low.
• Interest rate diagram:

  A rate of interest above P means the supply of money exceeds money, causing the rate to fall. The interest rate remains at equilibrium unless the demand for or supply of money changes
• Liquidity trap diagram

  This is when a change in the supply of money doesn't change interest rates. This means the conventional monetary policy can't be used to influence consumption and investment, so quantitative easing is introduced.

  
• What are the two types of supply-side policies?

  1. market-based: designed to allow the free market to work efficiently by removing any barriers to ent

  ry2. intervention: designed to correct market failures, whereby the free market fails to allocate resources efficiently.
• What is the main interventionist policy?

  Training and education. This is government spending on human capital.
• Interventionist policies: effects on economic growth: productivity

  T&E results in workers who are more skilled and hence more productive. A rise in productivity means that an economy is producing more output with the same amount of input, which causes the LRAS curve to move to the right and production to increase from Y1 to Y2.

  
• Interventionist policies: effects on unemployment: cyclical unemployment

  Because government expenditure boosts aggregate demand, the unemployment rate initially falls. However, because labour is a derived demand, more employees will be required to help firms deal with the spike in consumer demand. This is referred to as cyclical unemployment.
• Interventionist policies: effects on unemployment: structural unemployment


  As workers are equipped with a variety of skills, this eliminates problems associated with occupational immobility, whereby workers are unable to switch jobs due to a mismatch between the skills firms require.
• Interventionist policies: effects on inflation: inflationary effects

  Even though t&e shifts the demand curve to the right, the inflationary effects are eliminated by the outwards shift of the LRAS curve. However, this assumes both curves shift outward by the same amount, which in a real-world scenario may not be the case.
• Interventionist policies: effects on inflation: E.O.S

  Some may argue that prices fall rather than rise because as firms experience a surge in demand, they can exploit EOS, whereby the average costs fall as more output is produced. As costs are usually passed onto consumers in prices, lower costs will translate to lower consumer prices.
• Interventionist policies: effects on current account: financial account

  Government spending on T&E would also improve the state of the financial account because economic growth has historically translated to more FDI, as foreign firms are attracted by higher profit margins and domestic demand.
• Interventionist policies: effects on current account: current account deficit

  The fall in consumer prices would cause the goods and services in the UK to become more price-competitive relative to other countries. If the economy experiences more exports then, assuming imports remain constant or decreases, the current account is reduced.
• interventionist policy: T&E evaluation

  There is a time lag and should not be used for issues that need to be fixed immediately. Spending on T&E is relative to other countries. e.g if the quality of education is poor in the UK and high in Germany, then investing in T&E won't necessarily make the price of goods and services lower than in Germany, as there may still be a significant difference in the quality of education between the two countries.
• What are 3 examples of market-based policies?

  1. privatisation2. deregulation3. reducing corporation and income tax
• Market-based policies: effect of deregulation

  By allowing firms to function more freely, there is potential for productivity to increase, which would in turn reduce prices for consumers, helping to achieve the 2% target and improve economic welfare.
• Potential conflicts between macroeconomic objectives: economic growth vs inflation

  A growing economy is likely to experience inflationary pressures on the average price level.This is especially true when there is a positive output gap and AD increases faster than AS.
• Potential conflicts between macroeconomic objectives: economic growth vs current account

  During periods of economic growth, consumers have high levels of spending. In the UK, consumers have a high marginal propensity to import, so there is likely to be more spending on imports.This leads to a worsening of the current account deficit.However, export-led growth, such as that of China and Germany, means acountry can run a current account surplus and have high levels of economic growth.