Monetary Policy Flashcards
Functions of money
Medium of exchange
Store of value
Standard of deferred payment
Unit of account
Aim of monetary policy
Manipulation of interest rates and money supply to influence AD and help keep macro-economic stability in the economy and achieve price stability (low and stable inflation)
Base rate
The rate at which the Central Bank is willing to lend to commercial banks
Savings rate
The rate at which commercial banks reward customers for depositing money
Borrowing rate
The rate at which commercial banks lend customer money at
LIBOR rate
The interbank rate
The rate at which commercial banks lend to each other
Quantitative easing
A monetary policy action where a central bank purchases government bonds or other financial assets in order to stimulate economic activity
Advantages of quantitative easing
Wealth effect - lower IRs leads to higher share and bond prices so increases C, G and AD and decreases unemployment
Borrowing cost effect - QE lowers IRs on long term debts such as borrowing
Lower long term IRs keep business confidence high, increasing I and AD
QE depreciates exchange rate, improving price competitiveness of export industries
Alternative monetary policy to IRs and helps overcome liquidity trap when base rate is close to 0
Lowers threat of price deflation
Disadvantages of quantitative easing
Increase in monetary base might lead to inflationary pressure
Low IRs reduce annual income from pension funds
May contribute to rising wealth inequality due to surging house prices and rent
Ultra-low IRs distort allocation of capital and also keep zombie firms alive
How an increase in IRs affects:
people with mortgages
pensioners
firms with high loans
travel agent mostly specialising in abroad holidays
Homeowners have to pay higher repayments on mortgages so lower disposable income, causing negative wealth effect due to less confidence, reducing C and therefore AD
Pensioners receive a better return on savings because IRs increase so annual income from pension will increase - may reduce C as people want to make money through saving
Firms receieve higher repayment on loans due to increased cost of borrowing increasing cost of production shifting in SRAS so increasing unemployment
MPS increases so there is less demand for foreign holidays so C decreases but costs may decrease due to hot money inflows
Effect of a cut in IRs on economic growth
AD increases due to decreased saving
Eval: Can cause inflation, WPIDEC, SRAS shifts left due to weaker exchange rate
Effect of a cut in IRs on price stability (low inflation)
Demand pull infl\tion from AD and cost push inflation from WPIDEC as imports are expensive so cost of production increases
Eval: Not all firms import raw materials and depends on level of spare capacity, less inflation with a NOG
Interest rate channel (expansionary)
Expansionary monetary policy → decreases IRs for firms → increases I → increases economic activity → increases AD therefore RY and PL
Bank lending channel (expansionary)
Expansionary monetary policy → increase in bank loans to individuals → increases C → increases economic activity → increases AD therefore RY and PL
Exchange rate channel (expansionary)
Expansionary monetary policy → exchange rate depreciates → increases exports → increases economic activity → increases AD therefore RY and PL
Wealth effect channel (expansionary)
Expansionary monetary policy → rise in equity, land and house prices → rise in value of financial wealth → increases economic activity → increases AD therefore RY and PL
Interest rate channel (contractionary)
Contractionary monetary policy → increases IRs for firms → decreases I → decreases economic activity → decreases AD therefore RY and PL
Bank lending channel (contractionary)
Contractionary monetary policy → decreases in bank loans to individuals → decreases C → decreases economic activity → decreases AD therefore RY and PL
Exchange rate channel (contractionary)
Contractionary monetary policy → exchange rate appreciates → decreases exports → decreases economic activity → decreases AD therefore RY and PL
Wealth effect channel (contractionary)
Contractionary monetary policy → fall in equity, land and house prices → fall in value of financial wealth → decreases economic activity → decreases AD therefore RY and PL
Effect of a cut in IRs on low unemployment
More derived demand for labour
I increases as C increases so to meet demand firms expand - increased accelerator effect
Eval: Time lag as unemployment is a lagging indicator and if IRs are low, firms may borrow to invest, increasing capital to replace labour
Effect of a cut in IRs on balance of payments
X-M increases since low IRs cause less hot money inflows so the pound appreciates
Eval: Depends on PED as UK goods are more competitive in price terms after depreciation but depends on responsiveness of consumers and X-M may not improve if PL increases making goods less competitive
