monetary policy

• monetary policy is a demand side policy aimed at manipulating interest rates and the supply of money to influence macroeconomic goals
• what are the two types of monetary policy

  contractionary and expansionary
• contractionary monetary policies increase interest rates when there are high levels of inflation (usually in a positive output gap) by decreasing AD through one of it's components
• expansionary monetary policies reduce interest rates when there are low levels of inflation/deflation (usually in a negative output gap) so AD increases through one of it's components
• An interest rate is the reward of saving and the cost for borrowing expressed as a percentage of the money saved/borrowed
• what are the 4 impacts on consumption interest rates have

  1. increased incentives to save as interest rates are the reward of saving expressed as the amount of money borrowed
  2. higher mortgage payments so therefore less disposable income to consume
  3. higher costs of borrowing so fewer high value purchases
  4. higher costs of consumer credit
• what are the 4 impacts interest rates have on investment

  1. higher cost of borrowing as interest rates are the cost of borrowing and therefore loans would increase so less investment in capital goods
  2. higher costs of existing borrowing so less profit to retain to invest in capital goods
  3. lower business confidence so therefore less investment
  4. reverse accelerator theory
• hot money flows are flows of money that are moved into other countries to earn a short term profit on interest rate differences
• what are the 4 impacts that interest rates have on the imports and exports of a country?

  1. higher rates attract hot money flows into the country therefore appreciating the exchange rate, and the stronger pound means imports are cheaper so therefore they increase
  2. exports decrease as buyers switch to lower cost suppliers
  3. imports increase as imports become cheaper and domestic buyers switch to foreign producers
  4. net exports decrease overall
• money is a system of value that facilitates exchange of goods and services in an economy
• money fulfils four functions

  1. medium of exchange
  2. easily measurable
  3. standard for deferred payments
  4. must be able to be kept and used later
• the money supply is the total amount of money available within an economy at any given time
• what does a money market diagram look like

  
• central banks have 4 main roles
• the central banks first role is that they are bankers to the government and therefore hold cash as deposits, receive and make payments, sells bonds to commercial banks and to the public and acts as an advisor the the goverment
• the central bank's second role is that they are a banker to commercial banks
• the central bank's third role is that they regulate commercial banks
• the central bank's fourth role is that they conduct monetary policy (they manage the interest rate primarily through the supply of money)
• what are the 3 main advantages to monetary policy

  1. quicker to implement (as it's reviewed on a monthly basis unlike fiscal)
  2. easier to control (smaller adjustments can be made)
  3. not political (bank of England is independent from the government
• the two tools the monetary policy committee uses to implement monetary policy are interest rates and quantitative easing
• how does the monetary policy committee increase interest rates

  the bank of england would increase the bank rate which in turn influences the bank rates the commercial banks charge their customers
• how does the monetary policy committee decrease interest rates

  they decrease the bank rate which in turn influences the banks the commercial banks charge their customers
• the bank rate is the interest rate set by the bank of the england that determines the interest rates that the bank of england gives to commercial banks who pass it on to consumers
• quantitative easing is where the central bank buys assets such as bonds from banks and other financial institutions using newly created money which increases the money supply as banks have more cash and therefore they can lend more as the cost of borrowing is lower (diagram) and therefore there is increased investment and more spending
• when is quantitative easing used

  when inflation is low and interest rates can't decrease anymore
• weaknesses to monetary policy

  1. time lags (can take six months to feel effects)
  2. reluctance to borrow
  3. ineffective against cost push inflation
• a liquidity trap is where there are very low interest rates and people hold cash rather than spending and monetary policy becomes ineffective