Monetary Policy Overview

Question 1

What is Monetary Policy

Answer 1

It’s how central banks control money supply and interest rates to influence economic activity

Question 2

What’s the Role of Central Banks

Answer 2

Examples:
Bank of England
Federal reserve (Fed)
European Central Bank

How they influence the economy:
Manage money supply
Increase money supply → Lower interest rates → More borrowing & spending
Decrease money supply → Higher interest rates → Less borrowing & inflation control

Question 3

Four Key Tools of Monetary Policy

Answer 3

Open Market Operations - Buying and selling government bonds

Discount Lending - Loans from central bank to commercial banks

Reserve Requirements - Minimum deposits that banks have to keep hold of

Paying Interest on Reserve - Encouraging and Discouraging Bank Lending

Question 4

What are Open Market Operations

Answer 4

Open Market Operations are transactions in which a central bank buys or sells government bonds in the open market to influence the money supply and interest rates.

Question 5

What happens in Open Market Operations (OMO)

Answer 5

Central Bank buys or sells government securities (bonds) in the open market:

Buying bonds -> Increases Money Supply (Lowers interest rates, boosts borrowing)

Selling Bonds -> Decreases Money Supply (rises interest rates, slows inflation)

Question 6

What are the Advantages of Open Market Operations

Answer 6

1. Complete Control The central bank fully controls the volume of bonds bought/sold, allowing precise intervention.
2. Flexibility & Precision OMOs can be adjusted gradually to fine-tune effects. The central bank can scale up, slow down, or pause operations as needed.
3. Easy Reversibility Purchases and sales can be reversed easily (e.g. sell bonds to mop up liquidity after buying them). This is not possible with direct transfers to the public.
4. Quick Implementation OMOs are fast to deploy—no need for legislation or approval. They are simply market transactions.
5. Market-Based Tool They work through existing financial markets, aligning with the private sector rather than imposing controls.

Question 7

Disadvantages of Open Market Operations

Answer 7

1. Indirect Influence on Interest Rates OMOs adjust the money supply, hoping this will influence market interest rates. They don’t directly set rates like a policy rate change would.
2. Large-Scale Use Can Be Distorting Quantitative Easing (QE) expanded central bank balance sheets massively (e.g. £1 trillion in the UK, $10 trillion in the US). Managing and unwinding such huge positions can be challenging.
3. Risk of Market Dependence Markets may come to rely on central bank interventions, leading to distortions in asset prices or “addiction” to cheap liquidity.
4. Unequal Transmission The impact of OMOs may not spread evenly through the economy—some banks or sectors may benefit more than others.
5. Limited Effectiveness in Low Interest Environments When interest rates are already near zero (zero lower bound), OMOs may not stimulate borrowing/lending much, limiting their usefulness.

Question 8

What’s Discount Policy (Lender of Last Resort, loans of financial crisis)

Answer 8

It’s when central banks provide short term loans to commercial banks to manage liquidity

Types of Loans:
Primary Credit - For stable banks (lower interest rates)
Secondary Credit - For banks with liquidity issues (higher risk, higher rates)
Seasonal Credit - For small banks with seasonal demand (agriculture)

Question 9

What are Reserve Requirements

Answer 9

It’s the minimum percentage of deposits banks must have in reserves

Question 10

Different Types of Reserve Requirements

Answer 10

Required- The minimum amount of reserves that banks must legally hold and can’t lend out

Excess - Any reserves held above required minimum, which banks can keep or lend

Question 11

The Effects of Increased or Decreased Reserve Requirements

Answer 11

Increased -> Less Lending -> Higher Interest Rates:
More held funds reduce amount available to lend, money supply low so higher interest rates

Decreased -> More Lending -> Lower Interest Rates
Banks hold less reserve, needing more lending, leading to a higher money supply, leading to lower interest rates

Question 12

Why Reserve Requirement is Rarely Used

Answer 12

Sudden changes can disrupt liquidity
OMO and interest rates are preferred monetary policies

Question 13

What are the 3 Goals of Monetary Policy

Answer 13

Price Stability - Controls inflation and stability

Maximising Employment - Ensures job market stability

Promoting Economic Growth - Supports long term expansion

Question 14

Why is Price Stability Important

Answer 14

High inflation creates uncertainty in investment and plans

Reduces purchasing power, so money buys less over time (hurting low income groups)

Hyperinflation can cause economic collapse (Weimar Germany)

Question 15

Two ways Central Banks Maintain Price Stability

Answer 15

Set an inflation target (e.g. 2%)

Utilise Monetary tools (OMO) to regulate money supply and maintain stable inflation

Question 16

Why Maximising Employment is Important

Answer 16

Monetary policies aim to match demand with supply by having the lowest unemployment rate without triggering inflation

Stable employment leads to higher wagers, stronger demand, stronger economy

Question 17

How do Central Banks Promote Employment

Answer 17

Lowering interest rates to encourage borrowing and investments

Stabilise credit availability to allow businesses to expand and hire

Preventing unemployment spikes by stabilising economic fluctuation (adjust monetary policy)

Question 18

Why is Promoting Economic Growth Important

Answer 18

It leads to higher living standards

Creates Jobs and national wealth

Question 19

How Central Banks Support Growth

Answer 19

Keep inflation low and predictable to boost business confidence

Ensure financial system stability to allow smooth investments

Adjust monetary policy to support long term GDP growth