Chapter 32 - Monetary policy Flashcards
What is monetary policy?
Decisions made by the government regarding monetary variables such as money supply and interest rates
What is money supply?
The quantity of money that is in circulation in the economy
What are the 4 functions of money?
First, it is a medium of exchange. In other words, money is what is used when people undertake transactions - for example, when you buy a sandwich or a burger for lunch.
Second, money is a store of value: people (or firms) may choose to hold money in order to undertake transactions in the future. If this were not the case, there would be no reason for people to accept money in exchange for goods or services.
Money is also a unit of account: it is a way of setting prices so that the value of different goods and services can be compared.
Finally, money is a standard of deferred payment. Firms signing contracts for future transactions need to be able to set prices for those transactions.
What is the central bank?
The banker to the government, performing a range of functions, which may include issue of coins and banknotes, acting as banker to commercial banks and regulating the financial system
Who are the Bank of England?
The UK’s central bank
What is the ‘transmission mechanism of monetary policy’?
The channel by which monetary policy affects aggregate demand
How does ‘transmission mechanism of monetary policy’ work?
In drawing this analysis together, an important issue concerns the relationship between the rate of interest and the level of aggregate demand. This is critical for the conduct of monetary policy, because the interest rate has been seen as the prime instrument of monetary policy in recent years - and monetary policy is seen as the prime instrument of macroeconomic policy. By setting the interest rate, monetary policy is intended to affect aggregate demand through this.
What level of investment do firms have at higher interest rates?
At a higher interest rate, firms undertake less investment expenditure because fewer projects are worthwhile. In addition, a higher interest rate may encourage higher saving, which also means that households undertake less consumption expenditure. This may then reinforce the impact on investment because if firms perceive consumption to be falling, this will affect their expectations about future demand, and further dampen their desire to undertake investment. These factors lower the level of aggregate demand, shifting the AD curve to the left.
Notice that this may not be the end of the story. If one of the effects of the higher interest rate is to discourage investment, this will also have long-term consequences. Investment allows the productive capacity of the economy to increase, leading to a rightward drift in the LRAS curve. With lower investment, this process will go into reverse, leaving the economy with lower productive capacity than it otherwise would have had.
The AD/AS graph is drawn in terms of the overall price level. However, in a dynamic context, high interest rates may be needed in order to maintain control of inflation. A reduction in interest rates would, of course, have the reverse effect.
In creating a stable macroeconomic environment, the ultimate aim of monetary policy is not simply to keep inflation low, but to improve the confidence of decision-makers, and thereby encourage firms to invest in order to generate an increase in production capacity. This will stimulate economic growth and create an opportunity to improve living standards.
What is the influence of exchange rates on monetary policy?
In considering the transmission of monetary policy, it is also important to consider the exchange rate - that is, the rate at which one currency exchanges against another.
This is because the exchange rate, the interest rate and the money supply are all intimately related. If UK interest rates are high relative to elsewhere in the world, they will attract overseas investors, increasing the demand for pounds. This will tend to lead to an appreciation in the exchange rate - which in turn will reduce the competitiveness of UK goods and services, reducing the foreign demand for UK exports and encouraging UK residents to reduce their demand for domestic goods and buy imports instead. Under a fixed exchange rate regime, the monetary authorities are committed to maintaining the exchange rate at a particular level, so could not allow an appreciation to take place. In this situation, monetary policy is powerless to influence the real economy, as it must be devoted to maintaining the exchange rate.
Under a floating exchange rate system, monetary policy is freed from this role, but even so it must be used in such a way that the current account deficit of the balance of payments does not become unsustainable in the long run.
How does monetary policy work?
The monetary transmission mechanism explains the way in which a change in the interest rate affects aggregate demand in the economy. A fall in the interest rate is expected to have an expansionary effect on aggregate demand. In terms of the AD/AS model, this has the effect of shifting the aggregate demand curve to the right. The effectiveness of this will depend upon the shape of the aggregate supply curve and the starting position of the aggregate demand curve. This would be reinforced by the impact on the exchange rate.
An expansionary monetary policy intended to stimulate aggregate demand would be damaging if the economy were close to (or at) full employment, as the main impact would be on the overall price level rather than real output. This suggests that monetary policy should also not be used to stimulate aggregate demand. However, monetary policy can still play an important role in managing the economy. This arises through its influence on the price level and hence the rate of change of prices - that is, inflation.
What is inflation targeting?
An approach to monetary policy in which the central bank is given independence to set interest rates in order to meet an inflation target
Who are the Monetary Policy Committee (MPC)?
The body within the Bank of England responsible for the conduct of monetary policy
What is the bank rate?
The interest rate that is set by the MPC in order to influence inflation
What factors does the MPC take into account when considering interest rate?
Developments in:
- financial markets
- the international economy
- money and credit
- demand and output
- the labour market
- costs and prices (e.g. changes in oil prices)
What is the evaluation of monetary policy?
The prime objective of monetary policy is to control inflation, creating a stable macroeconomic environment in which firms will be encouraged to invest, so that economic growth will be achieved. Monetary policy is able to influence economic growth, but mainly by this indirect route. Similarly, by creating a stable macroeconomic environment, monetary policy creates the conditions in which economic agents can form reliable expectations about the future course of the economy, which allows a smooth adjustment to equilibrium.
The close relationship between monetary policy and the exchange rate means that the central bank must be aware of the possible impact of its decisions on the balance of payments. Raising the interest rate relative to other countries is likely to attract foreign investors, creating a surplus on the financial account, and putting upward pressure on the exchange rate. The end result is likely to be a deficit on the current account to balance the surplus on the financial account. Care must be taken to ensure that this is sustainable in the long run.
Monetary policy was used to try to stimulate aggregate demand in the recession that followed the financial crisis in an attempt to stabilise the economic cycle and to keep unemployment under control. However, this was a short-term measure, rather than an attempt to influence the long-run growth path. Other objectives of macroeconomic policy such as a fair distribution of income or a balanced government budget are tackled through fiscal measures. In other words, the effectiveness of monetary policy should be judged through its ability to meet the inflation target.
For a decade after the responsibility for monetary policy was delegated to the Bank of England, monetary policy was seen to be highly effective in enabling the achievement of the inflation target. However, matters then took a turn for the worse with the onset of the financial crisis and the ensuing recession, and inflation accelerated beyond its limit before coming back into range. In looking at the relationship between interest rates and inflation, it is useful to be aware that there are long time lags between initiating a change in the interest rate and the final impact on the inflation rate. The Bank of England has noted that it can take about 2 years before the full effect on inflation has worked through the system. Decisions about the interest rate therefore need to be based on the forecast of inflation between 2 and 3 years ahead.
The need to combat recession led to bank rate being reduced to 0.5% in March 2009. This situation creates problems for monetary policy, as having reached such a low level for bank rate, it is no longer possible to reduce the interest rate much further - it would not be possible for bank rate to be negative.
Keynes had pointed to the danger that such a situation would arise, referring to this as the liquidity trap. He argued that in a deep recession, monetary policy would become ineffective in affecting aggregate demand. Interest rates could fall no further, and any increase in money supply would be absorbed by an increase in the cash holdings of firms and individuals, as they would not buy financial assets with such a low return.
What is a liquidity trap?
A situation in an economy when interest rates can fall no further, and monetary policy cannot influence aggregate demand
What is quantitative easing?
A process by which liquidity in the economy is increased when the central bank purchases assets from the commercial banks
How does quantitative easing work?
The Bank of England announced that it would start to inject money directly into the economy, effectively switching the instrument of monetary policy away from the interest rate and towards the quantity of money. This would be achieved by a process known as quantitative easing, by which the Bank purchases assets such as government and corporate bonds, so releasing additional money into the system through the banks and other financial institutions from which it buys the assets. The hope was that this would allow banks to increase their lending, and therefore combat the threat of deflation - and perhaps help to speed recovery. This suggests that the Bank did not believe that the economy was in a liquidity trap, so that an increase in money supply could still affect aggregate demand.
So, how does quantitative easing work? The starting point is that the Bank of England uses electronically created money to buy high-quality financial assets, with the stated aim of improving the flow of credit in the economy, so allowing firms to obtain finance for investment.
The initial impact of asset purchases is intended to give economic agents confidence that action is being undertaken and to provide clear signals of policy intent. This will also encourage a rebalancing of portfolios, provide market liquidity and increase the supply of money. The improvement in confidence will affect asset prices and the exchange rate, as well as spending and income in the economy. This could also affect inflation, but this was considered less important than the recession that was building - indeed inflation was decelerating anyway. These other effects of the asset purchases will work together to reinforce the impact on asset prices and the exchange rate, with the increase in money supply operating through the impact on bank lending. The adjustment in asset prices and the exchange rate will also affect total wealth and the cost of borrowing, in turn affecting spending and income.
In this way, monetary policy can be used to mitigate the effects of recession, even with bank rate at its lowest point. The key part of this is the provision of credit to allow the economy to function more effectively. It is important to be aware that the UK was certainly not alone in facing this combination of circumstances. A number of countries had also enjoyed relative stability for several years, followed by a more turbulent period. This in itself suggests that the conduct of monetary policy cannot claim full responsibility for the period of calm, nor perhaps be entirely blamed for the subsequent problems.
What is the evaluation of demand-side policies?
Both fiscal and monetary policy operate through the demand side of the economy, affecting the position of the AD curve in order to influence the path of the economy. Whether intervention is needed in response to an external shock depends upon if the economy adjusts rapidly back to equilibrium at the natural rate, or whether the adjustment process is long and persistent. The financial crisis represented one of the greatest external shocks to hit developed economies since the Second World War. So how effective were demand-side policies in responding to the crisis?
In both the UK and the USA, a combination of fiscal and monetary policy measures were introduced. In terms of fiscal policy, governments on both sides of the Atlantic launched fiscal stimulus packages in the form of increased expenditure. In the UK, the government also introduced changes to direct taxes and implemented a temporary reduction in the rate of VAT. The strength of this approach is that the measures take effect quite quickly, and help to safeguard employment. However, the downside is that running a budget deficit in this way adds to public sector net debt, as the expenditures need to be financed.
Monetary policy was also used in an attempt to stimulate aggregate demand, through cuts in interest rates and quantitative easing. The need to bail out failing banks further added to public sector debt. The message from AD/AS analysis is that stimulating aggregate demand is not a solution to long-run economic growth, except insofar as it entails investment expenditure that adds to a nation’s productive capacity. Although the measures taken through demand-side policy during the financial crisis may have cushioned the impact, in the long run it is by supply-side policies that economic growth can be restored.
