Macro 12- Monetary policy

• Monetary policy is used to control the money flow of the economy. This is done with interest rates and quantitative easing.
• Expansionary monetary policy is when the central bank increases the money supply to increase AD
• Contractionary monetary policy is when the central bank increases interest rates to reduce AD
• What are the aims of Contractionary monetary policy?

  reduce AD

  Prevent credit bubbles

  reduce excess debt and promote saving

  reduce current account spending
• What are the aims of expansionary monetary policy?

  Increase demand pull inflation

  increase growth

  reduce unemployment
• Cons of expansionary fiscal policy

  demand pull inflation(conflict of macroeconomic objectives)

  current account deficit

  unsustainable growth= credit bubbles + liquidity trap

  negative impact on savers

  time lags
• evaluation of monetary policy

  size of output gap

  consumer confidence

  business confidence

  banks willingness to lend
• pros of contractionary monetary policy

  fall in inflation

  discourage household + corporate debt

  more sustainable borrowing

  increase in saving

  more affordable housing

  fall in current account deficit
• Cons of contractionary monetary policy

  lower growth

  higher unemployment

  impact of indebtedness

  fall in investment

  worsening of current account deficit
• What is the role of the central bank?

  implement monetary policy

  act as a bank lender

  lender of last resort to banks

  financial stability
• Factors considered by MPC in setting interest rates: Unemployment Savings Consumer spending Exchange rate
• What are asset bubbles?

  A rise in the prices of financial assets which increases their values above long run sustainable levels

  Prices can be driven because expectations of future price increases bring new buyers into the market
• What is a liquidity trap?

  a period of very low interest rates and a high amount of cash held by households and businesses fails to stimulate AD

  Occurs due to belief of interest rates rising soon
• How does Quantitative easing work?

  1. Central banks create money electronically
  2. This money is used to buy government bonds from financial institutes
  3. prices of government bonds increase which leads to the yield falling
  4. financial institutes either loan this money or invest in riskier corporate bonds
  5. Banks get more cash from asset purchases increasing their liquidity
  6. Improves access to credit and interest rates fall which means willingness to lend increases increasing loan financed capital investment
• Impacts of quantitative easing

  • cost push inflation due to depreciation of currency
  • the Bank of England can reduce the supply of money in the economy by selling their assets which reduces the amount of spending in the economy
  • reduces long term interest rates preventing investment