Macroeconomic Policy Revision - Monetary Policy

Following up from my fiscal policy revision notes, these are notes I made on monetary policy.  Again, apologies for the last diagram - I couldn't find it anywhere on the internet so had to make half of it in Paint... :P I think these notes are fairly comprehensive but please say something if you think of anything that could be added.

Hope they help!

~James

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  • Created on: 02-04-15 18:12
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Macroeconomic Policy Revison Notes - Monetary Policy
Definition: Managing the economy via the use of interest rates and the money supply.
Framework: Government sets the target for monetary policy to achieve in terms of inflation rate (currently
2.0% CPI +/- 1.0%). The Bank of England's Monetary Policy Committee (MPC) has responsibility for meeting
this target for inflation, altering interest rates and/or the money supply (through quantitative easing) in order
to influence CPI 18-24 months ahead.
Expansionary Monetary Policy: (Decreasing interest rates and/or increasing the money supply to boost
AD)
1) Decreasing Interest rates: Has the effect of increasing
consumption as the incentive for people to save falls due
to a reduced return from their savings. Also, the
repayment costs of variable rate mortgages will be
reduced meaning household's disposable discretionary
income will be increased meaning consumption will rise.
Consumption also rises due to the fact the consumer
borrowing becomes cheaper, so consumers are likely to
spend more on consumer durables (such as cars).
Decreased interest rates also effect investment, as the
cost of borrowing for firms decreases. This makes capital
investment more profitable, which makes firms more likely
to do it. The decrease in interest rates will decrease the
attractiveness of the Pound to foreign investors, and
therefore will decrease the flow of 'hot money' into the UK.
This will have the effect of reducing the demand for the £,
causing it to become weaker. This weakening of the currency will increase the international competitiveness
of our exports (W.P.I.D.E.C), and they will subsequently increase, causing an increase in AD.
2) Increasing Money Supply: This means banks have more money to loan to consumers and businesses and
therefore, makes them more likely to lend money. This increases both consumption and investment as funds
are now more readily available.
Contractionary Monetary Policy: (Increasing interest rates and/or decreasing the money supply to reduce
AD)
1) Increasing Interest rates: Has the effect of decreasing
consumption as the incentive for people to save rises due
to an increased return from their savings. Also, the
repayment costs of variable rate mortgages will rise
meaning household's disposable discretionary income
will be decreased meaning consumption will fall.
Consumption also falls due to the fact the consumer
borrowing becomes more expensive, so consumers are
likely to spend less on consumer durables (such as cars).
Raised interest rates also effect investment, as the cost
of borrowing for firms increases. This makes capital
investment less profitable, which makes less more likely
to do it. The increase in interest rates will decrease the
attractiveness of the Pound to foreign investors, and
therefore will raise the flow of 'hot money' into the UK.
This will have the effect of increasing the demand for the
£, causing it to become stronger. This strengthening of
the currency will decrease the international competitiveness of our exports (S.P.I.C.E.D), and they will
subsequently fall in quantity, causing a fall in AD.
2) Decreasing Money Supply: This means banks have less money to loan to consumers and businesses and
therefore, makes them less likely to lend money. This decreases both consumption and investment as funds
are now less readily available.

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Drawbacks of Monetary Policy
1) Significant Time Lags: - The monetary policy 'transmission mechanism' means it takes 18-24 months for
effects of the policy change to be felt in the economy.
2) 'Blunt' Policy Type: - Unlike fiscal policy, monetary policy cannot be used to target specific problems
within an economy.…read more

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