Monetary Policy

  • Created by: BKaur
  • Created on: 22-11-18 09:15

Government Policies

  • When the government wants to influence the economy, they have 2 options:
    • Change AD
    • Improve LRAS
  • There are 2 areas of policy available to governments:
    • Demand-Side Policies
    • Supply-Side Policies
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Demand-Side Policies

  • Used to achieve key macroeconomic goals - relating to growth, unemployment, inflation and the current account balance
  • There are 2 different types of demand side policies:
  • FISCAL POLICY: the use of taxes, government spending and government borrowing to achieve objectives
  • MONETARY POLICY: the use of monetary variables, such as interest rates, quantitative easing and the money supply, to achieve their objectives
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Monetary Policy

  • To some extent, the government can control the amount of money circulating in the economy
  • The government can influence the level of borrowing from banks and building societies
  • Governments can do this by using the instruments of policy
  • The government, through the Bank of England (the cental bank of the UK) has used two main tools:
    • Interest Rates
    • Quantitative Easing
  • The government will use interest rates and quantitative easing to try and get the economy out of the prolonged recession after the 2008 financial crisis
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Interest Rates as part of Monetary Policy

  • Rate of Interest: the price of money
  • Lenders or savers expect to receive interest on any money they lend or save
  • Borrowers will expect to pay interest on the funds they borrow
  • Interest rates increase = Cost of borrowing increases = Return on saving increases
  • Changing the rate of interest affects the economy through AD - if interest rates rise, AD will fall
  • There are a number of ways interest rates will affect AD:
    • Consumer Durables
    • The Housing Market
    • Wealth Effects
    • Saving
    • Investment
    • The Exchange Rate
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Interest Rates - Consumer Durables

  • Many people will buy consumer durables - such as furniture or cars on credit etc.

Rate of interest increases
=
Monthly payments increase
=
Sales of consumer durables fall
=
Consumer spending falls
=
AD falls

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Interest Rates - The Housing Market

Interest rates increase

=

People are put off buying/moving houses

=

AD falls (for 3 reasons)

1. As demand falls, less houses are built - this would be classified as investment in AD - so investment falls. This causes AD to fall

2. If less people move house, there will be fewer purchases of consumer durables, so consumer spending falls - causing AD to fall

3. People not moving house means less people release money, which could be spent on other goods

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Interest Rates - Wealth Effects

  • An increase in interest rates will decrease asset prices

Interest rates rise

=

Demand for housing falls

=

Price of houses fall; Government bonds fall in value

=

Homeowners and bond holders feel worse off so consumers spend less

=

AD falls

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Interest Rates - Saving

Higher interest rates

=

The reward to save is greater

=

Saving increases

=

Consumer spending falls

=

AD falls

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Interest Rates - Investment

Interest rates increase

=

More costly to pay back any money borrowed for investment

=

Profits can be saved rather than invested for better returns

=

Profitability falls

=

Investment falls

=

AD decreases

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Interest Rates - The Exchange Rate

Interest rates increase

=

Currency appreciates

=

Imports become cheaper; Exports become dearer

=

Imports rise; Exports fall

=

Net exports fall

=

AD falls

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Quantitative Easing

  • After the financial crisis of 2008, the UK government reduced interest rates to 0.5% - to stimulate AD
  • This did not work sufficiently, so the government introduced a policy of quantitative easing
  • QUANTITATIVE EASING: the process of the government buying financial assets from banks and other lending institutions
  • When the government buys assets from the bank (such as bonds), they are exchanging an illiquid asset for a liquid asset
  • The banks could not lend consumers a bond, so exchanging the bond for money means they can lend the money to consumers - this means they can lend more
  • Consumers and firms can borrow to purchase goods and fund investment projects
  • Consumer spending and investment should rise, so AD should increase
  • Quantitative easing also causes the interest rate to fall due to increased demand for bonds from the government purchasing bonds, meaning the price increases on the bond - this reduces interest rates
  • The fall in interest rate will have the same effects on AD - and possibly the exchange rate will depreciate
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The Role of the Bank of England

  • The elected government does not directly control monetary policy in the UK
  • This has been delegated to the Bank of England - so that the monetary policy is used on an independent basis
  • The key decisions are made by the Monetary Policy Committee (MPC)
    • this is 9 people from the Bank of England and other independent economic experts
  • At a monthly meeting, the MPC decide whether to change interest rates and whether to use quantitative easing
  • Main role of the MPC is to meet the inflation target of 2% in the UK
  • The Governor of the Bank of England has to write to the Chancellor if they miss the target by 1%and explain why this has happened, and how it will bring back inflation to 2%
  • The MPC also has a remit to make sure the economy is managed well - to consider growth and unemployment in its decision making
  • This explains the recent period of 0.5% interest rates, as the MPC have said they will not increase rates until economic growth is stronger and the negative output gap has shrunk
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