4.2.4

Question 1

What is monetary policy?

Answer 1

Monetary Policy is where there are changes to the interest rate, money supply and exchange rate by the central bank in order to influence AD. It can be either expansionary or contractionary.
Expansionary policy would be used to increase AD, increase inflation (to meet the 2% target), increase growth and reduce unemployment.
Contractionary policy would be used to reduce AD, reduce inflation and reduce current account deficit.
Transmission mechanism:
-Central bank cuts interest rates
-Reduced incentive to save
-Increased investment
-Weaker exchange rate - Hot money outflows
If monetary policy results in an increase in investment, LRAS will shift due to an increase in the quality and quantity of capital, as well as an improvement in the productive capacity of the economy.

Question 2

What are the drawbacks of using a cut in interest rates as monetary policy?

Answer 2

• Demand pull inflation
• Current account deficit - Increase growth results in higher incomes which will increase spending on imports.
• Negative impact on savers - reduced return on savings - If inflation>nominal interest rates, real value of savings will fall
• Time lags - Typically takes 18 months to 2 years to take effect

Question 3

Monetary policy eval

Answer 3

• Size of the output gap - Keynes diagram can be used to show how interest rates will mostly lead to inflation if there is a small output gap.
• Consumer confidence - will there be an increase in expenditure
• Business confidence - will there be an increase in investment
• Are banks willing to lend - if not there will be no increase in investment
• Size of the rate cut - A larger cut is more desirable due to the greater incentives it provides.

Question 4

When has monetary policy been used recently?

Answer 4

Expansionary Monetary Policy was used drastically during the Covid pandemic. Interest rates were cut to 0.1% (lowest rate ever from the central bank) and there was massive QE used, with £450 billion being pumped into the economy (20% of GDP).
This policy was used in order to stimulate growth, reduce unemployment and increase inflation (avoid deflation). However, now it can be seen higher rates of inflation (9%) due to the increased AD.
Therefore, now the central bank is adopting Contractionary Monetary Policy in order to reduce inflation and slow the growth. Interest rates have been raised to 1% and quantitative tightening is being used. This is used with the goal of reducing inflation, encouraging saving and having sustainable growth. However, there is a high risk of a demand side shock (possibly leading to a double-dip recession), negative impact on the indebted and a reduction of investment.