Monetary Policy

Question 1

Define Monetary Policy

Answer 1

Changes to interest rates, the money supply and exchange rates by the central bank to influence aggregate demand

Question 2

What are the reasons for Expansionary Monetary Policy?

Answer 2

1. Reduce Unemployment
2. Increase Growth
3. Increase inflation to a target rate

Question 3

What are the reasons for Contractionary Monetary Policy?

Answer 3

1. Reduce Inflation
2. Reduce Current Account Deficit

Question 4

What is the Monetary Policy Transmission Mechanism?

Answer 4

1. The central bank cuts interest rates
2. This leads to lower borrowing costs which increase consumption through incentivising
3. Savings decrease as the rate of return decreases, increasing consumption
4. Lower interest rates on business loans increase the marginal propensity to invest
5. Weakening of the exchange rate [hot money outflows] as they move money elsewhere for the best rate of return

Question 5

What are the conflicts of Expansionary Monetary Policy?

Answer 5

1. Demand Pull Inflation
2. Current Account Deficit
3. Liquidity Trap
4. Time Lags
5. Negative Impacts on Savers

Question 6

Explain Liquidity Trap

Answer 6

A keynesian argument that interest rates have a lower bound, and lose their effectiveness over time - When the interest rates are extremely low, households and businesses may have already covereted assets into more liquid forms, such as cash, but rather than facilitating it for activity, they may hoard it. Therefore, cutting interest rates further may not have signficant impact on influencing AD as economic agents have an abundance of cash.

Question 7

Explain Time Lags

Answer 7

It takes a long time for an interest rate cut to feed through the transmission mechanism and boost AD. The Bank of England claims it takes 18 months to 2 years for a interest rate cut to influence aggregate demand.

Question 8

What are some Evaluation Points to consider for the Effectiveness of Expansionary Monetary Policy?

Answer 8

1. Size of the Output Gap
2. Business and Consumer Confidence
3. Commerical Bank Behaviour
4. Size of the Cut itself

Question 9

Explain Output Gap

Answer 9

If the economy is close to YFE with a small negative output gap, it may boost aggregate demand and economic growth, but not very substantially. There could be a higher trade off in demand pull inflation. Vice versa [a recession] , the interest rate cut has a greater effect

Question 10

Explain Consumer and Business Confidence

Answer 10

Economic agents need to feel confident in future prospects / state of the economy, demand and profitability - this will determine a reason to invest when interest rates are lower

Question 11

Explain Commerical Bank Behaviour

Answer 11

The interest rate cut may be wasteful if commerical banks are not willing to pass on the cut to households and businesses possibly due to uncertainty

Question 12

Explain the Size of the Rate Cut

Answer 12

It may be worthwhile effectiveness if the magnitude of the cut is higher, as it makes borrowing and investment cheaper, increasing disposable incomes and incentives which boosts aggregate demand.

Question 13

What are the reasons for Contractionary Monetary Policy

Answer 13

1. Reduce Demand-Pull Inflation
2. Reduce Current Account Deficit
3. Flexibility for Expansionary Monetary Policy in the next crisis

Question 14

What are the cons of Contractionary Monetary Policy?

Answer 14

1. Demand Side Shock - Lower growth and higher unemployment
2. Reduced Investment - SR and LR growth
3. Worsening of the CA Deficit through Exchange Rate Strengthening
4. Philips Curve Argument

Question 15

Explain Worsening of the CA Deficit through Exchange Rate Strengthening

Answer 15

Hot money inflows can flood into a countries financial institutions due to higher interest rates, which increases demand for the currency, appreciating the currency and causes export prices to rise and import prices to fall, reducing export revenue and increasing import expenditure in the AD equation.

- could increase growth if costs of production are lowered

Question 15

Explain the Philips Curve Argument

Answer 15

An economic model by Bill Philips, that shows the conflict between unemployment and inflation. A low and stable rate of inflation will lead to a sacrifice of the unemployment target, increasing unemployment in the economy. [vice versa]

Question 16

What are some Evaluation Points of Contractionary Monetary Policy?

Answer 16

1. Commerical Bank Behaviour
2. Actions of Other countries
3. Consumer and Business Confidence

Question 17

Explain Commerical Bank Behaviour

Answer 17

An increased rapo rate is a burden for commercial banks to borrow from the central bank - although the central bank may raise interest rates, the commerical banks may not pass these onto consumers if they believe lending at lower interest rates generates profits

Question 18

Explain Point 1 of Actions of Other Countries

Answer 18

In order to control inflation, a central bank may increase interest rates to discourage borrowing and investment. Other countries may keep their interest rates low, which could encourage the home countries firms to borrow from foreign banks, which can lead to a fall in investment that is not substantial to influence AD.

Question 19

Explain Point 2 of Actions of Other Countries

Answer 19

If the interest rates of the home country are higher than those of abroad, foreigners may put more money into commerical banks of the home country to gain a higher rate of return. This increases the funds available for the commerical banks to lend, which may not reduce consumption and investment

Question 20

Explain Consumer and Business Confidence

Answer 20

Changes in unemployment, spending, borrowing, economic growth and such depends on the optimism of economic agents. For example, if the country is facing a boom, growth is rampant, which can increase the optimism of economic agents in terms of economic growth and investments.