Lec 9 - Monetary Policy (Continued)

Question 1

Relationship between Bank of England and Government.

Answer 1

The independence of the Bank of England from politics is important for providing a stable environment for business and investment.

Government sets goals for the Bank of England and then the Bank is free to determine policy in order to meet those goals.

Question 2

Bank of England Goals

Answer 2

Price stability is the key goal and a contributor to growth and employment.

The mission statement of the Bank of England emphasises achieving the inflation target is essential for enabling further targets to be met.

However, there are short-run trade-offs.

Question 3

Rationale for an Inflation Targeting

Answer 3

There are two main benefits from adopting an inflation target:

The Bank of England’s policy actions are more clearly understood by financial traders.

The target provides an anchor for expectations about future inflation.

With few surprises and firmly held inflation expectation, people and firms can make better economic decisions, which help make the allocation of resources more efficient.

Question 4

Controversy About Inflation Targeting

Answer 4

Critics argue that by focusing on inflation, real GDP or employment might suffer.

Critics justify their argument with the commonly agreed fact that there are short run trade-offs between employment and inflation.

Supporters of inflation targeting argue two main points:

By keeping inflation low and stable, monetary policy makes the maximum possible contribution towards achieving full employment and sustained economic growth.
‘Look at the record’.

Question 5

Actual Inflation & the Inflation Target

Answer 5

Between 2004 and 2016, the inflation rate average was 2.3% a year.

Although the average is very good, consideration must be made to the fact the actual level was quite volatile.

The target level is currently set at 2%.

Question 6

The Conduct of Monetary Policy

What are the four policy tools?

Answer 6

The Bank of England has four policy tools to influence the quantity of money and the interest rate:

Bank Rate
Open market operations
Lender of last resort
Required reserve ratio

Question 7

Bank Rate Definition

Answer 7

The interest rate that the Bank of England charges on secured overnight loans to commercial banks.

The basic reference interest rate in the economy.

Question 8

Influence of Bank Rate

Answer 8

Bank Rate is the Bank of England’s official policy interest rate to which other interest rates are linked.

Among them are the interest rate that the Bank pays to commercial banks on their reserve deposits and the interest rates that commercial banks pay on deposits and charge on loans.

The bank rate influences the short term and long term interest rates and thus impacts investment, consumption, net exports, aggregate demand and real GDP.

Question 9

Open Market Operations Definition & Purpose

Answer 9

The purchase or sale of securities by the central bank in the loanable funds market.

Allows the Bank of England to get the Bank Rate to move to the target level.

Question 10

Open Market Operations In Practice

Answer 10

If the central bank wants to increase the supply of money in the economy, it enters the market for Bonds (British Government Bonds) and buys some, paying with cash it has ‘printed’ and thus increasing the stock of cash in the economy.

Reducing the money supply is achieved by selling Bonds, receiving the cash paid by investors and destroying it.

Question 11

Monetary Policy Transmission - Bank Rate

What is the effect of lowering the bank rate?

Answer 11

When the Bank of England lowers Bank Rate:

1 Other short-term interest rates and the exchange rate fall.
2 The quantity of money and the supply of loanable funds increase.
3 The long-term interest rate falls.

4 Consumption expenditure, investment and net exports increase.
5 Aggregate demand increases.

6 Real GDP growth and the inflation rate increase.

Question 12

Monetary Policy Transmission - Exchange Rate Fluctuations

Answer 12

The exchange rate responds to changes in the interest rate in the UK relative to the interest rates in other countries − the UK interest rate differential.

But other factors are also at work, which make the exchange rate hard to predict.

Question 13

Monetary Policy Transmission - Money and Bank Loans

Answer 13

When the Bank of England lowers Bank Rate, the quantity of money and the quantity of bank loans increase.

Consumption and investment plans change.

Question 14

Monetary Policy Transmission - Long-Term Real Interest Rate

Answer 14

Equilibrium in the market for loanable funds determines the long-term real interest rate, which equals the nominal interest rate minus the expected inflation rate.

The long-term real interest rate influences expenditure decisions.

Question 15

Monetary Policy Transmission - Expenditure Plans

What is the effect of a change in bank rate on expenditure plans?

Answer 15

The ripple effects that follow a change in Bank Rate change three components of aggregate expenditure:
Consumption expenditure
Investment
Net exports

The change in aggregate expenditure plans changes aggregate demand, real GDP and the price level.

Question 16

Bank of England Fights Recession

What decisions do the monetary policy council make to close the recessionary gap?

Answer 16

The MPC lowers bank rate.
BoE conducts an open market purchase to increase supply of reserves.

Increase in monetary base increases supply of money, interest rate falls and quantity of money demanded increases.

Increase in supply of loanable funds lowers long-term interest rate and increases investment.

Increase in planned expenditure increases aggregate demand. This outward shift is increased by the multiplier effect.

Question 17

Bank of England Fights Inflation

What decisions do the monetary policy council make to close the inflationary gap?

Answer 17

The MPC raises bank rate.
BoE conducts an open market sale to decrease supply of reserves.

Decrease in monetary base decreases supply of money, interest rate rises and quantity of money demanded decreases.

Decrease in supply of loanable funds raises long-term interest rate and decreases investment.

Decrease in planned expenditure decreases aggregate demand. This inward shift is increased by the multiplier effect.

Question 18

Monetary Policy Transmission - Loose Links & Long, Variable Lags

Answer 18

Long-term interest rates that influence spending plans are linked loosely to Bank Rate.

The response of the real long-term interest rate to a change in the nominal interest rate depends on how inflation expectations change.

The response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict.

The monetary policy transmission process is long and drawn out and doesn’t always respond in the same way.

Question 19

Extraordinary Monetary Stimulus - Requirement in 2008-9 Recession
(What were the three main events?)

Answer 19

There were three main events that put banks under stress:
Widespread fall in asset prices
A significant currency drain
A run on the bank

Question 20

Extraordinary Monetary Stimulus - Effect of Events

Answer 20

When asset prices fall, banks incur a capital loss and if prices fall enough, banks’ liabilities exceed their assets.

A large currency drain leaves the banks short of reserves.

A run on a bank occurs when depositors lose confidence and withdraw funds. The bank loses reserves, calls in loans, sells securities at low prices and its equity shrinks.

Question 21

Extraordinary Monetary Stimulus - Policy Actions

Answer 21

There were four UK policy actions:
Interest rate cuts
Bank bailouts
Quantitative easing
Macro-prudential regulation

Question 22

Extraordinary Monetary Stimulus - Interest Rate Cuts

Answer 22

The Bank of England’s first and natural response was to lower Bank Rate.
But it acted slowly at first because it was more concerned about the risk that inflation would exceed the upper bound of its target than it was about the risk of recession.

It wasn’t until the crisis deepened with massive bank failures in the US and tottering UK banks that interest rates fell steeply.

Question 23

Extraordinary Monetary Stimulus - Bank Bailouts

Answer 23

With a run on Northern Rock, the Bank was concerned that UK banks would fail.
The goal of these bailouts was to ensure that the banks didn’t fail.

Failure would have had brought an enormous crash in the quantity of money (bank deposits) in the UK economy.

The UK government, not the Bank of England, made the bold policy moves.

Question 24

Extraordinary Monetary Stimulus - Quantitative Easing

Define the term

Answer 24

Quantitative easing (QE) occurs when the Bank of England creates an increase in the monetary base by buying government bonds and high grade corporate bonds in the open market.

The sellers of these bonds might be commercial banks but they also are pension funds and insurance companies.

Question 25

Extraordinary Monetary Stimulus - Quantitative Easing (Explain how it works & its purpose)

Answer 25

The idea is that QE would make the banks flush with excess reserves, which they would lend to firms and households thus consumption expenditure and investment would increase.

Aggregate demand and real GDP would grow more quickly.

With short-term interest rates as low as they can go, the goal of QE was to increase the monetary base and lower long-term interest rates.

The QE did not lower long-term interest rates and it did not bring a large increase in bank lending and the quantity of money.

Question 26

Extraordinary Monetary Stimulus - Macro-Prudential Regulation

Answer 26

Definition: regulation of the monetary financial institutions and financial markets to lower the risk of crisis and failure of these institutions and markets.

Key components: assignment of responsibility for oversight and monitoring of financial institutions and markets and rules governing the liquidity and scale of own funds for financial institutions.

Question 27

Supply Side Effects of Monetary Policy

Answer 27

Supply Side Impacts of monetary policy come through the impact of investment on the aggregate production function (the productivity curve).

Lower interest rates stimulate investment and lead to improvements in productivity in the economy.

Hence LAS shifts out.

These impacts are thought to be slow and dominated in the short run by the demand side impacts.

Question 28

Overall Effects of Monetary Policy

Answer 28

Overall, the impact of monetary policy in the economy depends on the relative sizes of the movements in the AS and AD curves.

Assuming that AS is relatively unaffected by monetary policy, then, in the long run, the only impact of monetary policy is on prices.

The proposition that changes in the money supply lead, in the long run, only to price changes has been referred to as the “Quantity Theory of Money”, which says that if the money supply rises by X%, then, in the long run, prices will also rise by X%.