3.2 Monetary Policy Flashcards
(19 cards)
What is the definition of money ?
Money can be anything that people regularly use to buy G/S and for the repayment of debts
What are the functions of money ?
- medium of exchange - it allows us to buy and sell G/S that we want, this allows trade and specialisation, without money we would have a barter system which leads to double coincidence of wants
- store of value -
- Unit of account
- Standard for deferred payments -
What are the Characteristics of money ?
To be used as money, a commodity needs to have the followings characteristics:
- portable (ideally have low weight)
- divisible (into smaller units without loss of value
- durable (non-perishable)
- difficult to forge
What is the definition of monetary policy ?
- monetary policy involves the manipulation of the bank rate, the supply of money or the exchange rate (with fixed exchange rate), to influence economic performance
- monetary policy in most countries is conducted by the central bank
What are the roles of the Bank of England ?
- it acts the governments bank
- it acts as the lender of last resort
The main role however is to conduct monetary policy to meet the UK government’s current inflation target of 2% +-1
what is monetary policy ?
monetary policy involves the manipulation of the bank rate, the supplyof money to influence economic performance
how does the bank rate affect loan rates ? And why might commercial banks not change loan rates
- if the BoE raises the banl rate, banks typically increase their interest rates on loan and mortgage rates
- this is because commercial banks now find it more expensive to borrow from the BoE, they pass on the hinncreased lending costs to their customers in order to maintain profit
- however banks may not always cut loan rates in response to fall in bank rate if they feel borrowers may default and the loans are too risky e.g 2008 crash banks were short on liquidity, they were relectuant to lend (credit crunch)
rate for savers is reverse logic
how does a decrease in the bank rate affect coupon rate on government bonds ?
when the central bank lowers the bank rate and hence market rate savers may look for alternative ways to save their surplus of funds, they purchase government or cooparate bonds
when there is an increase in demand for govenrment bonds, the market price for bonds on secondary markets increase, this will likely reduce the bond yeild, therefore the government may reduce the coupon rate offered on new government bonds, which reduces the borrowing costs for government
what is the monetary transmission messanism ?
this is process by which changes in monetary policy influence market rates of interest, asset prices, confidence and the exchange rate; all these variables affect AD and the rate of inflation.
how does the bank rate affect market interest rates hence AD ?
- reducing the bank rate will tend to reduce market interest rates, this is because borrowing costs for banks are likely to fall
- as market rates of interest fall, borrowing should become cheaper for households anf frims, the reward for saving also falls
- this leads to an increase in C and I by firms
- AD increases
how does the bank rate affect asset prices ?
- a reduction in the bank rate, hence market rates, lead to increased borrowing and increase in demand for assets
- this increases asset prices e.g houses, shares and bonds
- as asset prices increase, there is an incrwase in wealth for households and firms
- increase C and I should increase, increasing AD
how does the bank rate affect confidence ?
- a reduction in the bank rate can lead to consumers and firms feeling more confident about the future as it indicates loosening of monetary conditions
- improved expectations of fuuture income and profits will likely lead to increases borrowing the finance increased expenditure by households and firms. this should lead to an increase in consumption and investment, thus increasing AD
what are the 4 types of unconventional monetary policy ?
- asset purchases or quantative easying
- funding for lending scheme
- foward guidance
- negative bank rate
what is quantative easing ?
- the BoE buys government and cooporate bond from non bank fiancial institutions e.g pension funds
- the increased demand for bonds cause the the market price to go up, meaning the bond yeild decreases
- the leads to new bonds being issued at a lower interest rate, this lower rate feeds through to other interest rates
- thus boosting consumption and investment
What are the advantages of monetary policy ?
- Changes in monetary policy may take less time to influence markets and therefore AD compared to fiscal policy, since commercial banks will likely respond to a change in the bank rate by manipulating their own bank rate relatively quickly.
- The bank rate can be changed by a small amount gradually, leading to less fluctuations in economic activity and possibly leading to less uncertainty for firms and households.
- Monetary policy is flexible in the sense that if banks decide to make a change to the base rate which doesn’t achieve the intended outcome they meet regularly and can possibly reverse the initial change
- Monetary policy decisions are made independently of the government which means they are less likely to be influenced by political objectives and can focus on achieving their inflationary targets
What are the disadvantages of monetary policy ?
- Monetary policy on its own may not be sufficient to overcome a major economic shock such as the 2007/8 global financial crisis, in this case significant expansionary fiscal policy may be required to correct the economy
- Changes in the bank rate may not be the most influential factor determining aggregate demand as it may be more significantly effected by other factors such and consumer and business confidence.
- market interest rates may also be reflected by other factors such as lenders confidence and willingness to risk lending money, which may lead to reduced credit creation (credit crunch), possibly rendering the change in the bank rate as insignificant.
What are the disadvantages of monetary policy ? Part 2
- There is a limit on how low the bank rate can go, though negative bank rates are possible there is a greater chance of a liquidity trap
- Monetary policy is subject to time-lags for the full policy to take effect, the full effect on output may be experienced since bank rates are changed gradually
- Quantitative easing can have potentially negative wealth and income distribution effects since as asset prices increase this is likely to increase the wealth of higher income households who own these assets
What are the evaluation points of the effectiveness of monetary policy ?
The effectiveness of monetary policy in (achieving….) may depend on:
- the size of the change in the bank rate, as well as the initial interest rate (if interest rates are very low, monetary policy may be less effective)
- whether the reduction the bank rate is passed on by commercial banks; this could be influenced by competitiveness in the financial sector and the confidence In the economy
- the level of spare capacity (how close to productive capacity) and whether **monetary policy is being used together with effective supply-side policies
What are the evaluation points of the effectiveness of monetary policy ? Part 2
- the size of the multiplier effect
- consumer and business confidence
- the extent to which other factors affect the levels of AD in the economy, such as fiscal policy and other conflicting policy objectives
