Monetary Policy Flashcards
(17 cards)
Advantages of monetary policy part 1
- Changes in monetary policy can instantly influence financial markets, via commercial banks decisions on their own interest rates. Thus, monetary policy can take less time then some forms of fiscal policy
- The bank rate can be changed gradually to minimise significant fluctuations in economic activity - less uncertainty
- Monetary policy is flexible. MPC meet every six weeks
Advantages of monetary policy part 2
- Unlike fiscal policy, monetary policy decisions are made independently of the government. This leads to monetary policy being less influenced by political objectives
- Monetary policy decisions are based on a comprehensive assessment of the economic outlook
- MPC decision must also be consistent with other government objectives such as growth and low unemployment
Disadvantages of monetary policy part 1
- Monetary policy may not be enough to overcome an economic shock (COVID 19). Fiscal policy may also be required
- Changes in the bank rate may not be the most influential factor affecting AD. Other factors, such as consumer and business confidence may be more influential
- Monetary policy is subject to a limit on how low it can go (negative interest rates are not likely)
Disadvantages of monetary policy part 2
- Firms and households having access to to globalised financial markets may reduce the effectiveness of monetary policy in domestic economy
- Monetary policy is subject to time lags. Effect on output may actually be observed before the impact on inflation (however associated time lags with it are usually smaller than some forms of social policy)
- Quantitative easing can potentially have negative distributional effects. As assets prices increase, this is likely to increase the wealth of higher income households who hold these assets
Forms of unconventional monetary policy
- Asset purchases or quantitative easing
- Funding for lending schemes
- Forward guidance
- Negative bank rate
Negative bank rate
Under a negative interest rates commercial banks have to pay an interest charge for holding their reserves at the central bank. This does not necessarily mean that firms and household also face negative interest rates. The intended effect is to reduce the market interest rates in order to boost consumption, investment and net exports.
Forward guidance
The central bank provides information about the intended future path of monetary policy to provide greater certainty for firms and households
Funding for lending schemes
It is designed to encourage banks and building societies to expand their lending and non financial corporates, by providing funds at cheaper rates than those prevailing in current markets. Both the quantity and the price of these funds are linked to the amount of lending the banks do. The lower question of L+FLS funds should then be passed on to consumers in lower borrowing costs.
Asset purchases or quantitative easing
QE involves the government buying government bonds or corporate bonds from pension funds and other financial companies (i.e non bank financial assets)
Increased supply of bonds causes the price of bonds to go down. Thus increasing bond yields.
This causes other market interest rates to go up, thus boosting AD
Also, the pension funds and other financial companies are likely to use the proceeds of the sales of the bonds to purchase other assets such as property of shares. This will increase the wealth of household and businesses which own these assets.
Monetary transmission channels
1 - market interest rates
2 - asset prices
3 - confidence
4 - lower interest rates
Market interest rates (transmission channel)
- reducing the bank rate will to reduce market interest rates. This is because borrowing costs of banks are likely to fall
-as market rates of interest fall, borrowing should become cheaper for household as and firms; the rewards for savings also fall
-increase in consumption and an increase in investment for firms as the cost of borrowing to infancy capital also falls - C and I are components of AD so AD increases
Asset prices transmission channel 2
- a reduction in the bank rate and hence lower market interest rates lead to increased borrowing and an increase in demand for asset
- this is likely to cause asset prices to go up (houses, shares, bonds)
- reducing the rate of return (yield) on those assets
- as asset prices increase, there could also be an increase in the cost of borrowing against the value of assets as household and firms have a greater wealth C and I should increase -»> AD increases
Confidence transmission Chanel three
-A reduction in the bank rate can lead to consumers and firms feeling more confident in the economy about the future, as it indicates an easing of monetary conditions
- improved expectations of future income and profits is likely to increase borrowing to finance increased expenditure by household, firms. Increase in C and I —»» increase in AD
Transmission channel 4 exchange rate
Lower interest rates lead to depreciation of domestic currency. A depreciation should increase demand for exports as exports become cheaper to buyers. Imports become more expensive for domestic buyers. As net exports increases AD will increase.
Expansionary monetary policy
A cut in the bank rate
Contractionary monetary policy
An increase in the bank rate
Evaluation of monetary policy
1- the size of the increase/ decrease in bank rate
2 - whether the reduction in the bank rate is passed on by commercial banks
3 - the level of spare capacity in the economy at the initial macroeconomic equilibrium
4 - the extent to which the productive capacity is being affected by monetary policy or whether monetary policy is being used in conjunction with effective supply side measures
