Monetary Policy

Monetary Policy define

Involves the manipulation of the money supply and rate of interest by the monetary authorities

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Purpose of Monetary Policy

1) control rate of inflation, UK inflation target of CPI is 2%, 2) Maintain stable economic growth

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Tools of Monetary Policy- 1) Inlfation target

The bank of england is responsible for keeping inflation close to target

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Monetary Policy Tools - 2) Interest rates

Interest rates influence economic activity through influencing the cost of borrowing

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Monetary Policy Tools - 3) Quantitative Easing

Occurs when Central Bank electronically creates money to buy assets helping to reduce interest rates on bonds and increase money supply (used in 2009-12 when lower interest rates were not enough to boost demand)

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Tight Monetary Policy Define

involves increasing interest rates to reduce AD

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Tight Monetary Policy- 1

Higher interest rates make borrowing more expensive therefore consumers spend less on credit and firms are less willing to invest by borrowing money

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Tight Monetary Policy- 2

Cost of mortgage payments increase, people have less disposable income casusing fall in consumption

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Tight Monetary Policy- 3

Saving money in a bank is more attractive- therefore there is less spending in the economy

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Tight Monetary Policy- 4

Exchange rate increases because more people want to save in countries with her interest rates (hot money flows)- The appreciation in the exchange rate makes UK goods look relatively more expensive, depressing domestic demand

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Tight Monetary Policy- 5

Higher interest rates, tends to reduce demandfor buying houses causing lower house prices causing a negative wealth effect, reducing consumer spending further

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Diagram- describe

Higher interest rates reduce AD and therefore decrease inflation: HOWEVER likely to conflict with other macro objectives

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Evaluation of Monetary Policy in reducing inflation- 1

If AD falls, the effect on inflation depends upon the position of the economy and slope of AS curve eg at full capacity higher interest rates will have a significant effect on reducing inflation

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Evaluation of Monetary Policy in reducing inflation- 2

Depends upon other variables affecting AD eg if confidence is high, increased interest rates may not reduce inflation, If confidence is low (2009) zero interest rates may not be sufficient to promote economic recovery

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Evaluation of Monetary Policy in reducing inflation- 3

Higher interest rates cause an appreciation in the exchange rate, will reduce AD and reduce price of imports helping to reduce inflation

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Evaluation of Monetary Policy in reducing inflation- 4

If inflation is due to cost push factors (rising oil prices) we get higher inflation and lower output- difficult to solve both cost push inflation and lower output through use of interest rates. MPC would have to choose eitherinflation or output

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Loose Monetary Policy define

Involves reducing interest rates to promote economic growth

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Explain loose monetary policy

Will increase spending, investment and AD and therefore lead to higher real GDP HOWEVER may conflict with other macro economic objectivessuch as higher inflation and depreciation in exchange rate

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Role of Central Bank- 1

Maintain price stability- target id CPI 2% (+/-1)

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Role of Central Bank- 2

Issuing of notes and coins

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Role of Central Bank- 3

the banker of commercial banks

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Role of Central Bank- 4

acting as a lender of last resort, commercial banks can borrow from B of E

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Role of Central Bank- 5

Setting interest rates -every month MPC meets to decide on base interest rates which influence economic activity

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Role of Central Bank- 6

Adopting monetary policy such as quantatitive easing

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Benefits of MPC setting Monetary Policy-1

MPC have been successful in keeping inflation close to its target

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Benefits of MPC setting Monetary Policy- 2

Low inflation is important for ensuring stable and continuous growth

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Benefits of MPC setting Monetary Policy- 3

The govt could always change the target if there was a shock to the economy

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Benefits of MPC setting Monetary Policy- 4

Argued that the use to set interest rates depending upon political considerations eg before an election, interest rates were cut to increase growth, the independance of the MPC should avoid this problem

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Criticisms of MPC setting Monetary Policy-1

An inflation target is not enough, If MPC just targets inflation could lead to lower growth or higher unemployment

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Criticisms of MPC setting Monetary Policy- 2

If there are shocks to economy such as higher oil prices may increase inflation making it difficult to keep within the govt target

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Criticisms of MPC setting Monetary Policy- 3

Fine controls of the policy are not possible because it is difficult to get accurate information about economy

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Criticisms of MPC setting Monetary Policy- 4

Low inflation between 1997-07 could be due to other factors such as increased productivity, better technology and low prices of raw materials

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Criticisms of MPC setting Monetary Policy- 5

The MPC were unable to prevent asset bubble and resulting credit crunch in 2007-09 shows limitations of relying on interest rates along

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Criticisms of MPC setting Monetary Policy- 6

Monetary policy may not be enough, Keynesians argue there is need for expansionary fiscal policy if we are in a deep recession where low interest rates don't boost demand

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Monetary Policy

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