Monetary Policy Revision Flashcards
1
Q
What economic factors does the Bank of England consider?
A
- current rate of inflation
- unemployment rate
- savings rate
- exchange rate
- consumer/business confidence
- current interest rates
- global commodity
- house prices
2
Q
What are interest rates?
A
The cost of borrowing and the reward for saving
3
Q
Are market interest rates the same as BoE base rates?
A
No
4
Q
What is the bank of englands main objective?
A
2% CPI ± 1
5
Q
What are things to talk about when describing the impact of a change in the BoEs base rate of interest
A
- savings/borrowing
- overall demand in the economy
- unemployment/wages
- real output
- inflation
6
Q
How are asset prices impacted by a rise in the BoEs base rate of interest?
A
- Banks will likely increase interest rates on savings/loans
- mortgages will be more exspensive
- less buyers within the housing market
- house prices decrease
- negative wealth effect
7
Q
What is the wealth effect?
A
the change in spending that accompanies a change in perceived wealth.
8
Q
How does an increase in the base rate of interest cause an appreciation
A
- Increase value of the £ due to an increase in hot money inflows due to rising interest rates (therefore return)
- PP of £ increases
- imports cheaper
- SRAS shifting right/down
- downward pressure on prices
9
Q
Why may there be an unemployment due to increase in IR
A
Increase saving -> less consumption/demand -> price down -> revenue down -> laying off workers/decrease in wages
10
Q
Name nine evaluative points for the effectiveness of using interest rates
A
- De coupling
- Time lags
- Willingness to borrow might fall despite interest rare cuts
- Liquidity trap
- No control over cost push pressures
- Danger of causing an asset bubble
- Position and shape of LRAS
- Globalised capital markets
- Asymmetric impact on high net savers and borrowers
11
Q
What is a recession
A
a significant decline in economic activity spread across the economy
12
Q
What are the main macroeconomic objectives of a government?
A
- to improve the living standards of the citizens in a matter that is
-
sustainable in the long run and equitable so that all citizens benefit
Whilst providing a stable macroeconomic environment in the short run by ensuring that there is - steady real economic growth, low unemployment, controlled inflation and an equilibrium in the balance of payments
13
Q
Monetary policy attempts to achieve…
A
Macroeconomic objectives by manipulating the price (interest rates) and/or quantity of money (supply) in an economy (AD)
14
Q
Who is monetary policy managed by?
A
- the Bank of England
15
Q
If interest rate increases, what effect will this have on consumers?-
A
- savings will increase
- interest payments on mortgages & existing loans increases
- house prices and financial asset prices will decrease
- this leads to less income available for consumption -> decrease in consumption
- AD decreases and inflation goes down
16
Q
If interest rate increases what impact will this have on businesses?
A
- interest payments on existing loans will increase
- costs of new loans to fund investment will increase
- retained profits will decrease
- leading to a decrease in investment + AD
- decrease in inflation
17
Q
If interest rate increases what impact will this have on the exchange rate?
A
- export prices will increase - decrease in export qty
- import prices will decrease - increase in import qty
- (X-M) decreases and AD decreases
- inflation decreases
18
Q
How does quantity easing work?
A
- The central banks creates electronic money and buys government bonds in the secondary market (from commercial banks) e.g the Bank of England created £375bn in the aftermath of the financial crash
(Impact on supply of loans) - This has the effect of increase the liquidity of commercial banks
- This encourages commercial banks to lend (as there is an increase in confidence to the increase in cash) and the supply of loans in the credit markets increases (S1 to S2)
(Impact on demand for loans) - Simultaneously, bond prices in secondary markets to increase with the increased demand for bonds
- As a result bond yields go down
- Commercial interest rates tend to be benchmarked against bond yields so they go down
- This encourages consumers and firms to borrow
(Impact on Economy) - In this way, QE encourages both the supply and demand for loans which in turns stimulates AD and inflation
19
Q
Describe the correlation between the Bank of England and commercial bank interest rates.
A
- It sets an interest rate which affects commercial banks deposits with it
- It hopes that when it changes this rate commercial banks will follow and change the interest rate they charge.
- A benchmark interest rate is LIBOR which is used as a reference point against which other rates are set
- FInancial transactions between consumers and firms in the economy are intermediated by commercial banks
- interest rates that afffect behaviours are those set by commercial banks
- If commercial banks do not follow interest rate signals of the B.o.E then monerary policy is ineffective in influencing AD and Inflation
20
Q
When is monetary policy ineffective?
A
- When interest rates can’t go any lower and an expansionary policy is required
- When financial institutions do not follow the central banks interest rate or money supply changes
- When consumer/business confidence is low so they do not borrow
- When savings and/or borrowings are low so the magnitude of the impact of the transmission mechanisms is low
- In globally inter-connected financial markets when savers and borrowers can ignore domestic monetary signals and save/borrow overseas
- When fiscal policy conflicts with monetary policy
21
Q
What is the impact of quantities easing on equity?
A
- QE involves purchasing financial asset prices
- Prices of financial assets increases
- People who already own financial assets become better off and can increase their income to become even richer - distribution of wealth gets more unequal
- The quantity & price of assets being purchased increases the financial sectors earnings as they earn a % of each transaction.
- this increases the incomes even more of those in this sector while ad is being decreased, increasing income inequality
22
Q
What impact does QE have on pensions?
A
- As QE involves purchasing financial asset prices with a view to driving down interest rate
- price of financial assets go up, yield of financial assets goes down
- pension funds calculate their future liabilities to pay annuities based on these yields
- as yields go down the value of these annuities they can pay go down - hurting the working population more than current pensioners
- govt. regulations require pension funds to increase their holdings of financial assets so that they can continue to pay the annuities they have committed to
- employees and firms have to increase pension contributions now
23
Q
What is disposable income?
A
- the money that households have left from their salary/wages after they have paid their taxes and received any transfer payments
24
Q
When savings decrease consumption…
A
Usually increases
25
How does an increase in interest rates affect consumption?
- creates a greater incentive to save
- therefore less consumption
- monthly repayment on loans/mortgages increase
- less consumption
- some may spend more as they already have a lot saved
26
The stronger the economy, the higher the consumer confidence therefore…
- consumers feel secure in their jobs and are confident of receiving regular salary payments
- consumption increases and saving decreases
27
Describe the wealth effect
- If asset prices rise homeowners wealth increases
- increasing homeowners consumption as they have more consumer confidence to borrow money
- if asset prices fall then homeowners wealth decreases
- homeowners start saving to replace lost wealthj
Eval: most homeowners believe prices fluctuate so ignore
28
How do interest rates affecting investment?
- most investment by firms is financed through business loans
- decreasing interest rates encourages investment
- inverse relationship between investment and interest rates
29
What is decoupling (of base rates and commercial interest rates)
When the change in base rate is not passed onto borrowers
30
What is the credit crunch (2008-2011)
Banks borrowed off the BoE at lower rates but lent to customers, firms and each other at increased rates of interest
31
Why did the credit crunch happen?
1. Banks trying to repair their batter balance sheets by increase their profit margins on money lent out
2. Higher interest rates reflected greater risk of lending during a recession and uncertainty
3. Banks had reduced access to funds from ‘wholesale money markets’ and thus less access to cash that could be loaned out
The supply of available funds to lend out fell
32
What is a time lag
It can take up to 2 years for the full effects of interest changes to be felt in the macroeconomy.
Base rate = set to control future inflation rate
However, impacts of an interest range change can have immediate effect on consumer and business confidence
33
Why might willingness to borrow fall despite interest rate cuts/
- consumers are saving more to repair debts and put money aside in case of unemployments (which is common in a recession such as in 2009)
- firms are risk adverse due to uncertainty about eurozone crisis and are unwilling to borrow
- firms have spare capacity due to recent recessions (2009-10, 2011-12) and do not need to borrow to fund investment
34
What is a liquidity trap?
- when interest rates cannot be cut further and monetary policy is less effective
- 0.5% is when it is maxed out
35
What is the most pressing issue with monetary policy?
No control over cost push pressures:
- no influence over inflationary pressures from price changes in globally traded commodities (oil, gas, wheat)
36
What are asset bubbles
- when assets prices rise rapidly and significantly above their fundamental value
37
How can low interest rates create the danger of causing an asset bubble in the longer term
- causes excessive borrowing and asset bubbles due to high demand for assets
- during the NICE decade, low interest rates and large supply of cheap credit pushed house prices to unsustainability high levels
- the bursting of bubble had massive consequences, as many sub-prime loans were dependent on house price rises.
- contributed to the financial crisis and recession
38
How do globalised capital markets limit monetary policy
- there may be a large supply of credit available to consumers due to high savings rate in the far east
- commercial interest rates will remained low and credit availability will remain high, borrowing and spending will not be impacted
39
Describe how asymmetric impact is a limitation of MP
- debt is eroded in real terms
- savings are eroded, reducing wealth, reducing consumer confidence and spending
40
Describe the relationship between bond price and yields
Inverses
41
What is the equation for yields?
Coupon/market prices
42
How much worth of bonds has the Bank of England purchased by 2020
£895bn in total
43
What are limitations of QE?
1. Will lead to high inflation in the future, as when the economy recovers there is an abundance of cash to lend and borrow. Increasing AD by more than its usual amount and creating high inflation
2. QE has to be reversed at some point. The Bank of England cannot just hold £475bn worth of assets forever. They will have to sell these assets back to the free market, therefore reducing prices and increasing yields and interest rates
3. QE hasn’t actually helped the “average Joe” at all. It has just increased financial liquidity of banks and financiers, boosted the stock market, and inflated asset prices. Real wages are not improving and still many people struggle to borrow at reasonable interest rates.
4. Banks have not used their extra liquidity and cash to give out necessary loans to firms. They instead have used the cash to bolster balance sheets and buy inflated assets. (*Decoupling*)
44
What are bonds?
Bonds are IOUs that pay an amount of interest that is fixed in cash terms - £5 per year, for example. This fixed interest payment is called the bond’s ‘coupon’.
45
What is QT?
Quantitative tightening
- not buying other bonds when the bonds we hold mature, selling bonds to investors or both
- aim of qt is to ensure it is possible to undertake QE agai
46
Monetary is a ….-side policy
Demand
- affects the level of investment spending and consumer spending
47
I how did the central bank support the economy after the financial crisis
Bought £200 of assets for qe (2009)
48
We in the Great Recession:
In response to the 2007–2009 financial crisis, the Federal Reserve decreased interest rates and significantly expanded its balance sheet through quantitative easin
49
We in the Great Recession:
