LS12 Booklet

• fiscal and monetary policy targets aggregate demand
• central bank uses monetary policy to influence the economy with interest rates and quantitative easing to get out of recessions
• quantitative easing is when the central bank buys government bonds from financial institutions, increasing their cash reserves. this increases the incentive for banks to lend more, stimulating economic activity
• effects of quantitative easing:

  • increases money supply
  • reduced long term interest rates
  • encourages investment and spending
• demand side policy - policies aimed at influencing aggregate demand in the economy to achieve economic objectives such as growth and employment
• fiscal policy involves the use of government spending and tax (revenue) to influence aggregate demand in the economy
• expansionary monetary policy aims to increase aggregate demand and economic growth. This involves cutting interest rates or increasing money supply to boost economic activity
• contractionary monetary policy is when the central bank seeks to reduce the demand for money and limit the pace of economic expansion by increasing interest rates
• impact of interest rates on consumer durables:

  • lower interest rates makes loans cheaper. this encourages purchases of durables
  • the higher the interest rates, the greater the monthly repayments on sum borrowed
  • higher interest rates leads to lower sales of durable goods, hence lower consumption expenditure
• impact of interest rates on housing market:

  lower rates reduce mortgage costs, increasing demand for houses
• impact of interest rates on wealth effects:

  • lower rates increases the price of assets.
  • for example, lower interest rates leads to increased demand, which in turn pushes up the price
  • This increases the value of assets
• impact of interest rates on savings and investment:

  • lower interest rates reduces the incentive to save because the cost of borrowing is cheaper
  • cheaper borrowing encourages firms to invest in projects and investments
  • this boosts economic activity
• impact of interest rates on exchange rates

  • lower interest rates can lead to a weaker currency
  • this is because foreign investors seek better returns elsewhere
  • a weaker currency makes exports cheaper and imports more expensive
  • this improves the trade balance
• Increase in supply of money on interest rates

  
• Impact of contractionary policy on AD and AS

  
• explain how a reduction in interest rates affects consumer spending on durable goods:

  • Lower interest rates make loans cheaper
  • increases the incentive to take loans out and spend.
  • This will encourage the sale and purchase of durable goods
  • therefore increasing consumption expenditure.
  • For example, a reduction in interest rates can reduce the mortgage of housing.
• discuss the impact of quantitative easing on the UK economy during a recession:

  • The central bank buys government bonds from financial institutions
  • increases their cash reserves.
  • This increases the government’s incentive to lend more,
  • leading to an increase in money supply. 
• Bank rate: 

  • the interest rate set by the central bank that influences borrowing and lending rates in the economy. 
  • It is the interest rate at which a nations central bank lends money to domestic banks - often through short term loans
• Market rates:

  • set based on the bank rate
  • The interest rate charges by banks and financial institutions for loans 
• Official rate:

  • changing the official rate alters the cost of borrowing across the economy
  • Rate set by the MPC is the repo rate which is the rate the central bank will charge in the money market for short term loans to other banks/financial institutions 
• Money market rate:

  • other rates such as mortgage and credit card rates are affected by official rate
• If official rate decreases, market rates decreases. Leads to loans becoming cheaper which will encourage borrowing and spending. When consumption increases, AD increases which further causes inflation to increase ceteris paribus
• Cut in official rate decreases market rates. Loans and mortgages will become cheaper. Households will borrow more to purchase housing. Leads to increase in demand for houses leading to increases in asset prices. Owners of these assets feel wealthier increases consumption and then AD which increases inflation.
• Consumer confidence and expectations - changes in official interest rate affect expectations. If economic agents expect economy to benefit from interest rate cut, investors would increase investments and consumers will be more confident in the economy, giving the incentive to spend.
• Official interest rate decreases - currency depreciated due to capital flight. Foreign investors will look for more profitable options in other countries. 
• Change in exchange rate - leads to changes in net external demand (demand for country’s exports) as well as import prices. When exchange rate depreciates, exports become more competitive and imports less attractive. This increases AD and improves trade balance. 
• Official rate increases - causes hot money flows to increase because investors start to invest more in UK assets. This will cause the exchange rate to appreciate because there is excess demand for the pound. However, the UK’s exports will become more expensive to foreigners which reduces net exports and also reduce AD. So inflation will also decrease. 
• When market rates increase, existing loans become more expensive to repay. This would reduce consumption, and so AD and inflation decreases too. 
• Monetary policy transmission mechanism:

  • process by which changes in interest rates affect the economy
• If bank rate is increased:

  • market rates increase so inflation decreases because loans are more expensive to repay. 
  • Exchange rate appreciates because there’s excess demand for the pound from foreign investors.
  • Asset prices decreases because loans and mortgages become more expensive, which reduces demand and consumption 
  • Economic agents become less confident in the economy, so investors will decrease investments  
• If interest rates fall, official rates and market rates decrease so loans become cheaper which encourages more borrowing. Consumption will increase so AD increases which causes demand pull inflation.
• Liquidity trap - situation where an increase in money supply has no effect on interest rates, AD or economic growth because economic agents prefer saving money instead of investing it. 
• Time lags - the time it takes for monetary policy to come into action and have their full effect on the economy. Ranges between 18-24 months.
• Expansionary monetary policy aims to increase AD and economic growth
• Expansionary monetary policy - cutting interest rates or increasing money supply to boost economic activity
• Contractionary monetary policy- implies the central bank is seeking to reduce the demand for money and limit the pace of economic expansion 
• Increase in money supply doesn’t increase interest rates or stimulate investment due to liquidity trap

  
• Limitations of monetary policy:

  • difficult to control many objectives with just interest rates. Eg. Increasing interest rates to control inflation will reduce inflation, but will also cause economic growth to fall as well
• Limitations of monetary policy:

  • Changing interest rates affects the exchange rate. An increase in interest rate or reduction in money supply causes appreciation in exchange rate which makes exports less competitive 
• Limitations of monetary policy:

  • Interest rates may affect some parts of the economy more than others. Eg. Higher Interest rates increases  disposable income but also makes homeowners unable to afford their mortgages