8.3 - Monetary Policy & Central Banks (from ppt)

Monetary policy 1. How is the money supply controlled?

1) Credit Limits through base controls. - Places limits on the amount of money commercial banks can lend out. - Reserve asset ratio (which define how much a bank must hold in cash to their assets). 2) Buying and selling of Government Bonds

Monetary policy instruments: 1. Quantitative easing

A Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target. Government sells bonds to financial institutions (banks) BoE creates cash to buy the bonds from the banks and so puts money into banks Households and businesses ask banks for loans As banks have more money interest rates fall

What is "Monetarism" What do Monetarists (e.g. Milton Friedman) believe the main cause of inflation is?

An economic theory that states that inflation should be controlled by the money supply. Inflation is always and everywhere a monetary phenomenon. The main cause of inflation is an excess supply of money in an economy leading to what Milton Friedman says is "too much money chasing too few goods"

Monetary policy instruments 1. Open market operations 2. What is meant by Open market operations? (Brief)

Buying and selling gilts (bonds) the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system, facilitated by the central bank. Purchases inject money into the banking system and stimulate growth, while sales of securities do the opposite and contract the economy. Where the Bank of England sells short-term government securities and bills, thereby reducing retail banks' liquid assets and raising interest rates

Monetary Policy 1. Monetary Policy is concerned with affecting what? 2. MP can be either contractionary or expansionary: T / F ?

Demand for bank loans. Supply of credit (and creation of demand deposits). Central bank taking action to influence 1) Interest rates 2) Supply of money and credit 3) Exchange rate True

Monetary Policy 1. What is it to do with? 2. How does it influence AD? 3. Who's in charge?

Demand side policy. Manipulation of 1) Interest rates. 2) Money supply. 3) Exchange rate (very hard to do) Can be expansionary monetary policy (increasing AD) or contractionary monetary policy (decreasing AD). Central banks (MPC of the BoE) target inflation using interest rates, money supply and exchange rate (not the govt!! govt uses fiscal)

What does 'Macroeconomic stability' mean? What does 'Macroeconomic performance' mean?

Stable growth, stable employment, a stable price level, and stability in the current account of the balance of payments. Can be assessed by considering the extent to which these desirable objectives are being achieved

How is the interest rate determined? Draw model

(*on ppt*) Interest rate on y-axis. Quantity on x-axis. Demand (borrowers) and supply (savings in banks)

Consumption Loans and credit

Consumption falls because higher interest rates encourage saving (increases marginal propensity to save) -> less income is available for consumption. Cost of HH borrowing increases -> more money used for interest repayments. House prices fall -> consumer confidence falls. Cost of HH borrowing increases -> increases cost of servicing a mortgage and credit card debt. Borrowers have less money to spend on consumption because more of their money is used for interest repayments

Exports Imports

Exports fall. High interest rates -> increased demand for £ as owners of international capital want to hold UK currency -> hot money inflows -> £'s exchange rate increases -> decreases price competitiveness of UK exports in world markets -> exports fall -> balance of payments worsens. Imports increase as prices of imports fall since they become more competitive in UK markets. UK balance of payments worsens with the fall in net export demand shifting AD curve left. Falling exchange rate -> increases prices of imported food and consumer goods -> increases inflation in UK. Also, increased prices of raw materials and energy -> cost-push inflationary pressures int he UK [import cost push inflation]

A fall in interest rates results in ...

Fall in cost of borrowing. Fall in rate of return on savings. MUST MENTION BOTH.

Monetary policy instruments: 1. Forward Guidance

Forward guidance is a way of converting low short-term interest rates into lower long-term interest rates - making a promise about future interest rates. It is a way for the Bank to support the economy by estimating for how long such low interest rates may be around for in terms of months or years. If commercial banks can be convinced that low interest rates will remain low for longer, they will hopefully be more likely to lend money out for the longer term at a lower interest rate.

History of monetary policy: 1. What was a previous monetary policy objective (between 1985 - 1992)? Why? 2. Previous monetary policy objectives/instruments?

High exchange rate. To reduce the prices of imported goods (food, consumer goods, oil and raw materials) The aim was to reduce cost-push inflation. Before 2009 - Only Bank Rate used (pretty much) to manage demand for loans. 2009 - BoE introduces Quantitative Easing to influence commercial banks' ability to supply new loans to their customers

Monetary policy transmission mechanism 1. What is it? Draw it out 2. What is the relationship between changes in interest rates and the exchange rate? 3. Is there a time-lag involved with the transmission mechanism of monetary policy?

How changes in interest rates feeds through the economy to affect prices (inflation). 1. Changing interest rates or the money supply -> 2. Expectations/confidence. Borrowing costs. Return on saving. Exchange rates. -> 3. Consumption Investment. Net exports. -> 4. AD (CIG(X-M)) Domestic inflationary pressure. Yes. Time lag of up to 2 years between an initial change in Bank Rate and resulting change in the rate of inflation.

Monetary policy 1. Define interest rate. What do interest rates affect? 2. How are they each affected by high interest rates? 3. Name the model you use to show effect on interest rate 4. Is a negative interest rate possible? - Why would it be implemented? - How?

Interest rate is the 1) Cost of borrowing money 2) Rate of return on savings. Interest rates affect: 1) Consumption. 2) Loans and credit. 3) Exports. 4) Imports. 5) Investment. 6) Business confidence. 7) Consumer confidence (The reversed one) Yes. To avoid economy falling into persistent deflation. Reduce the flow of hot money -> depreciation of the value of the pound -> lower exchange rate -> increases price of imported goods -> inflation will rise -> helps achieve inflation target of 2%

Investment Business confidence Consumer confidence

Investment by firms on capital goods fall. Firms cancel or postpone investment projects at a higher cost of borrowing and wait for a lower cost of borrowing, believing in the future new capital goods can be more profitably used. Falls. Because falling consumption due to lower consumer confidence ... Falls. Falling house and share prices reduces personal wealth -> consumption decreases -> consumer confidence falls

What is meant by LIBOR? How does it operate?

LIBOR is the rate of interest at which banks lend to each other. LIBOR is determined on a daily basis by the demand and supply for funds as banks lend to each other to balance their books (whereas Bank Rate is set monthly by BoE). Normally, £-month LIBOR trades at a small premium of around 0.15% above where the market thinks the Bank Rate will be in 3 months' time. However, large divergence between the BR and LIBOR makes it difficult for the BoE to operate monetary policy effectively (as with LIBOR household savings were no longer the principal source of liquidity). *When LIBOR is significantly above Bank Rate, a cut in Bank Rate aimed at reducing the interest rates that the general public have to pay when borrowing from high-street banks is ineffective if the rates the banks charge is determined by LIBOR rather than by Bank Rate.*

Monetary policy instruments 1. Monetary Base Control - What is it? 2. If the BoE insist on a higher Reserve Asset Ratio what happens? 3. Draw the model

Limiting the ability of commercial banks to supply more credit through reserve asset ratios. Quantitative control - maximum limit on amounts banks can lend Qualitative control - only lend to certain types of customer. If the government wants to contract supply of money, they can restrict and limit either how much banks can lend or to whom they can lend.

What are the limitations of monetary policy?

Mortgage interest rates do not necessarily follow changes in the repo (base) rate Many are on fixed rate mortgages - time.... Many households rent their property Firms will not invest if they have spare productive capacity Many people live on the interest that savings provide - they will face a cut in disposable income There may be little reaction to a cut in rates Concentration on certain groups - exporters Side effects - other objectives affected

Monetary Policy Committee of the Bank of England (MPC) 1. What is the role of the MPC? 2. How does it use changes in bank rate to try to achieve the objectives of monetary policy, inc. the target rate of inflation. 3. What are the factors considered by the MPC when setting the bank rate?

Sets the interest rate each month Independent (sort of) Inflation target of 2% given by Government Markets, International, GDP, Labour market, Inflation Set Repo rate (the rate at which the central bank of a country lends money to commercial banks in the event of any shortfall of funds). 3. Financial markets International economy Credit figures Demand and output Labour market Costs and Prices

Open market operations: Expansionary Monetary Policy

The BoE purchases government securities through private bond dealers and deposits payment into the bank accounts of the organizations that sold the bonds. The deposits become part of the cash that commercial banks hold at the central bank, and therefore increase the amount of money that commercial banks have available to lend. Commercial banks actively want to loan cash reserves and try to attract borrowers by lowering interest rates, which includes the federal funds rate.

MPC of the BoE, decides on QE. Explain QE

The aim is to encourage spending, to keep inflation on track to meet 2% target. QE doesn't involve printing money. Instead, BOE electronically create new central bank reserves - the money that banks use to pay each other - and use this to pay for the assets it buys. When BOE buys gilts, it pushes up their price and so reduces the yield (the return) that investors make when they buy gilts. This encourages investors to buy other assets with higher yields instead, like corporate bonds and shares. As more of these assets are bought, their prices rise, pushing down borrowing costs for businesses, encouraging them to spend and invest more. BOE also buy a smaller amount of corporate bonds, making it easier for companies to raise money which they can then invest in their business. As interest rates have been cut close to zero, QE is another tool to stimulate the economy when demand is too weak.

Open market operations: Contractionary Monetary Policy

The central bank enacts a contractionary monetary policy when it wants to slow the economy. The BoE sells government securities to individuals and institutions, which decreases the amount of money left for commercial banks to lend. This increases the cost of borrowing and increases interest rates.

Monetary policy 1. What is the main monetary policy objective? 2. How does the monetary policy achieve its objective (main one) 3. How does the monetary policy achieve its objective? (3)

To control inflation (target 2%). The main monetary instrument is the interest rate (the price of holding money) - set by the MPC. Monetary policy involves the central bank taking action to influence interest rates, supply of money and credit and the exchange rate. Used to try to meet the 2% inflation target Changing interest rates Monetary Base Control Open Market Operations

Central bank 1. What are the main functions of the Central Bank? 2. What is the main objective?

To maintain financial stability (2% inflation target) To maintain macro economic stability (price stability, growth, employment) (1) Oversee the financial system. 2) Implementing the govt's monetary policy) 1) The Monetary Policy Committee at the BoE sets the UK's bank rate to meet the government's 2% inflation target. 2) As 'lender of last resort', the BoE will provide fuynds if commercial banks suffer a lack of liquidity -> helps maintain confidence -> therefore, helps maintain financial stability. 3) Regulation of banking (BoE important role through Prudential Regulation Authority). 4) Provides banking facilities to the UK's commercial banks To control inflation in order to create conditions in which the ultimate objective of improved economic welfare can be gained.

Monetary policy instruments 1. Define 2. Name the monetary policy instruments? (Conventional and unconventional). 3. How are they used?

Tools used to achieve the objectives of monetary policy. In the UK, they can involve the BoE taking action to influence interest rates, the supply of money and credit, and the exchange rate. Mainly using the Bank Rate and Quantitative Easing. 1) Changing interest rates (demand). 2) Monetary Base Control (canging the money supply). 3) Funding for Lending (canging the money supply). 4) Forward guidance. 5) Open market operations (supply). 6) Quantitative easing. A government will use Monetary policy to attempt to alter the level of aggregate demand in order to manage and achieve their macroeconomic objectives.