2.6.2 Monetary Policy

Question 1

Monetary policy

Answer 1

Used by the government to control the money flow of the economy with interest rates and quantitative easing. This is conducted by the BoE, which is independent from the government.

Question 2

Demand-side policies

Answer 2

Policies designed to increase consumer demand, so that
total production in the economy increases

Question 3

Monetary policy instruments

Answer 3

Interest rates
Quantitative Easing (QE): asset purchases to increase the money supply

Question 4

Interest rates

Answer 4

The Monetary Policy Committee (MPC) alters interest rates to
control the supply of money; they are independent from the government and the 9 members meet each month to discuss what the rate of interest should be.
- Interest rates are used to help meet the govt target of price stability since it alters the cost of borrowing and reward for saving.
- The BoE controls the base rate, which ultimately controls the interest rates across the economy: reduction in the base rate will lead to a rise in AD.
This happens through a number of transmission mechanisms.

Question 5

Increasing AD through reducing interest rates because:

Answer 5

• Consumption and investment increase due to lower costs of borrowing
• Higher consumption, due to lower borrowing, will mean that asset
  prices increase. This will lead to a positive wealth effect.
• Saving becomes less attractive, as a lower rate of return is offered, so consumption and investment both increase. Mortgage interest repayments are lower and so therefore consumers have more income left to spend, which also increases consumption.
• Lower interest rates reduce the incentive for investors to hold their
  money in British banks, so demand for the pound will fall. The pound will be weaker, so exports will be cheaper and imports more expensive, net trade will therefore increase.

Question 6

Quantitative easing QE

Answer 6

Used by banks to help to stimulate the economy when standard monetary policy is no longer effective. This has inflationary effects since it increases the money supply, and it can reduce the value of the currency.
QE is usually used where inflation is low and it is not possible to lower interest rates further.

Question 7

Bonding to increase and decrease money supply

Answer 7

QE (method to pump money directly into the economy) has been used by the European Central Bank to help stimulate the economy. Since the interest rates are already very low, it is not possible to lower them much more. The bank bought assets in the form of government bonds using the money they have created. This is then used to buy bonds from investors,
which increases the amount of cash flowing in the financial system. This encourages more lending to firms and individuals, since it makes the cost of
borrowing lower. The theory is that this encourages more investment, more
spending, and hopefully higher growth. A possible effect of this is that there could be higher inflation.
- If inflation gets high, the BoE can reduce the supply of money in
the economy by selling their assets. This reduces the amount of spending in the economy.

Question 8

Limitations of monetary policy

Answer 8

• Banks might not pass the base rate onto consumers, meaning even if the central bank changes the interest rate, it might not have the intended effect.
• Even if the cost of borrowing is low, consumers might be unable to borrow
  because banks are unwilling to lend. After the 2008 financial crisis, banks became more risk averse.
• Interest rates will be more effective at stimulating spending and investment when consumer and firm confidence is high. If consumers think the economy is still risky, they are less likely to spend, even if interest rates are low.