Monetary policy

• Monetary policy


  Changes to interest rates, the money supply, and the exchange rate by the central bank of an economy in order to influence aggregate demand
• Monetary policy


  Similar to fiscal policy, a demand-side policy
• Central bank


  Independent to the government, with a mandate to predominantly control inflation
• Bank of England's primary role

  To hit a 2% inflation target
• Expansionary monetary policy


  Policies that try to boost aggregate demand
• Contractionary monetary policy


  Policies that aim to reduce aggregate demand
• Expansionary monetary policy


  Used to boost aggregate demand and raise inflation if it is below target
• Expansionary monetary policy


  Also used to boost economic growth and reduce unemployment
• Contractionary monetary policy


  Used to reduce aggregate demand and bring inflation back towards the target rate
• Central banks' goals


  • Macroeconomic stability, in addition to inflation targeting
  • Protecting the financial sector from collapse
  • Preventing excessive growth of house prices and credit
  • Balancing economic growth, reducing excess debt, and promoting more saving
• Contractionary monetary policy can help reduce the current account deficit
• Interest rates


  The 'big daddy' of monetary policy
• Expansionary monetary policy via interest rate cuts


  1. Transmission mechanism:

  2. Lower credit card interest rates

  3. Lower savings interest rates

  4. Lower mortgage interest rates

  5. Lower business loan interest rates

  6. Depreciation of the exchange rate
• Expansionary monetary policy via interest rate cuts


  Increases consumption, investment, and net exports, boosting aggregate demand
• Expansionary monetary policy via interest rate cuts


  Can also increase long-run aggregate supply through increased investment
• Increasing long-run aggregate supply is a nice side effect, not the core intention of expansionary monetary policy
• When a central bank cuts interest rates


  There is a risk of demand-pull inflation as a trade-off as a conflict of macro objectives
• Expansionary monetary policy is successful at lowering interest rates


  Aggregate demand shifts right
• Aggregate demand shifting right


  Can lead to higher growth and lower unemployment but also higher demand-pull inflation
• Lower interest rates stimulate aggregate demand


  Can widen a current account deficit
• Liquidity trap


  When interest rates are already so low, consumers and businesses have already converted their illiquid financial assets into more liquid assets like cash, so further interest rate cuts will not be effective
• Interest rates fall


  Rate of return on savings falls, potentially becoming negative if inflation is higher than the nominal interest rate
• Expansionary monetary policy comes with time lags, taking 18 months to 2 years to fully feed through into the economy
• Output gap


  The difference between actual output and potential output
• When the economy is close to full employment with a small negative output gap


  Interest rate cuts will mainly lead to higher inflation rather than growth and reduced unemployment
• When the economy is in deep recession with a large negative output gap


  Interest rate cuts have greater potential to boost growth and reduce unemployment without much demand-pull inflation
• Consumer confidence


  Consumers need to be confident in their job prospects and future income in order for lower interest rates to incentivise borrowing and spending
• Business confidence


  Businesses need to be confident in future demand and profitability in order for lower interest rates to incentivise borrowing and investment
• If consumer confidence and business confidence is low


  Lower interest rates may not promote more borrowing for consumption or investment
• If banks are unwilling to lend


  Interest rate cuts by the central bank will be ineffective
• If banks do not fully pass on interest rate cuts


  The boost to aggregate demand will be limited
• Larger interest rate cuts


  Are more desirable to significantly incentivise borrowing and boost aggregate demand
• If interest rate cuts are ineffective, the central bank may use alternative measures like quantitative easing
• When a central bank cuts interest rates


  There is a risk of demand-pull inflation as a trade-off as a conflict of macro objectives
• Expansionary monetary policy is successful at lowering interest rates


  Aggregate demand shifts right
• Aggregate demand shifting right


  Higher growth and lower unemployment but higher demand pull inflation
• Lower interest rates stimulate aggregate demand


  Can widen a current account deficit
• Liquidity trap


  When interest rates are already so low, consumers and businesses have already converted their illiquid financial assets into more liquid assets like cash, so further interest rate cuts will not be effective
• Interest rates fall


  Rate of return on savings falls, potentially becoming negative if inflation is higher than nominal interest rates
• Expansionary monetary policy comes with time lags, taking 18 months to 2 years to fully feed through into the economy