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Macro Exercise 15

Macro Exercise 15

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Problem Focused Exercise: Monetary Policy- how is it decided?

1

The Scenario
The Monetary Policy Committee sets the interest rate each month in the UK. We explore how monetary policy affects the economy and the factors that are important in determining the Committee’s decision.

Task A

Read the short extract How Monetary Policy Works from the Bank of England’s website. From the article identify the following outcomes of a reduction in interest rates. (1) How does a reduction in interest rates affect a sequence of other things? Identify the direction of the changes in your answer. (2) (3) What economic objectives do interest rates affect? How do the effects need to be aggregated to consider the effect on the economy? What economic model (and associated diagram) is appropriate to use in such an analysis? feedback page 3

Task B
Read the extract from the Minutes of the Monetary Policy Committee meeting held on 3 and 4 August 2005. Given the evidence discussed by the Committee, consider whether this would lead the Monetary Policy Committee to increase, decrease or keep interest rates the same, and the size of any change. In doing this you should: • • • Use an appropriate diagram. Explain why the economic concept of the multiplier is important in determining the Bank’s decision. Discuss any difficulties that the Committee might have had in coming to a decision. feedback page 5 or 7

Copyright: Embedding Threshold Concepts Project

26/08/07

This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.

http://www. Higher house prices enable existing home owners to extend their mortgages in order to finance higher consumption. reduce the price of imports. tending to make sterling assets more attractive.htm Extract from the minutes of the Monetary Policy Committee meeting held on 3 and 4 August 2005 ‘In the first half of the year. http://www.uk/monetarypolicy/how. Borrowers tend to spend more of any extra money they have than lenders. Higher share prices raise households’ wealth and can increase their willingness to spend. which stimulates spending.pdf Copyright: Embedding Threshold Concepts Project 26/08/07 This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning. That can affect wage costs by changing the relative balance of demand and supply for workers. It seemed likely that the combined effect of high levels of household debt and the lagged impact of past interest rate increases had accounted for some of the unexpectedly sharp slowdown in consumer spending through 2004 and into the first quarter of 2005. Lower interest rates can affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans.uk/publications/minutes/mpc/pdf/2005/mpc0508. so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents. Lower interest rates can boost the prices of assets such as shares and houses.bankofengland.how is it decided? 2 How Monetary Policy Works From interest rates to inflation A reduction in interest rates makes saving less attractive and borrowing more attractive. the impact of interest rates on the exchange rate is. The opposite occurs when interest rates are increased.co. downside risks remained in the near term given the loosening in the labour market and uncertainty about the underlying strength of consumer spending in the first half of the year. into employment. and reduce demand for UK goods and services abroad. Household spending and business investment growth had slowed. The impact on output and wages feeds through to producers’ costs and prices. However. output growth in the United Kingdom had been subdued.Problem Focused Exercise: Monetary Policy. Although there had been some signs of a pickup in consumer spending in Q2. That should raise the value of sterling. Changes in spending feed through into output and. in turn. seldom that predictable. But it also influences wage bargainers’ expectations of inflation – an important consideration for the eventual settlement.co. It was possible that the uncertainty created by the ongoing adjustment in the housing market had also had some effect on spending. unfortunately.bankofengland. . Changes in interest rates can also affect the exchange rate. and eventually consumer prices.

how is it decided? 3 Feedback Task 1 (1) The article mentions a large number of ways interest rates affect other things in the economy. . (a) Some initial variables affected interest rates down savings down borrowing up share prices up house prices up (b) A sequence of effects from one of these variables Interest rates down house prices up consumer wealth up spending up (2) The economic objectives are output. employment and prices (3) Aggregation of the effects savings down/ borrowing up consumption and investment up Interest rates down asset prices up exchange rate down aggregate demand up exports up/imports down Copyright: Embedding Threshold Concepts Project 26/08/07 This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning. Examples are given in the relationships illustrated.Problem Focused Exercise: Monetary Policy.

This illustrates the changes in aggregate expenditure (demand).Problem Focused Exercise: Monetary Policy. (ii) The Keynesian cross diagram. If we are interested in the final effects on economic objectives this is arguably the best model to use. You could use: (i) The circular flow diagram – the above is suggesting that certain injections/withdrawals may be changing. There are several related diagrams that can be used. Figure 1: Aggregate Demand and Supply Case (a) LRAS P SRAS P5 P2 P1 P4 P3 AD2 AD1 Y1 Y2 Y Y3 Y4 AD2 SRAS Case (b) LRAS AD1 Y Copyright: Embedding Threshold Concepts Project 26/08/07 This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning. However this does not cover the effect on inflation. .how is it decided? 4 Feedback Task 1 (cont) Intermediate The question asks you to decide what model is appropriate to use The diagram(s) to be used in your answer depends to some extent on what you have covered in your course. but again does not cover the effect on inflation (iii) The IS-LM diagram can show the initial effect of the monetary policy change more clearly than other models. A fall in interest rates increases aggregate demand (AD) in figure 1 (we illustrate two cases as we shall use these in task B). but again does not cover the effect on inflation (iv) The AD/AS diagram – this does show the effect on prices (though it does not show the initial effect of the monetary policy as clearly as the IS/LM framework).

investment falls this will lead to a decrease in output. such as: * Are consumption (sales) and investment falling or only growing very slowly (paragraph 1 in the first extract)? * Are house prices and share prices falling or only increasing very slowly (paragraph 2 in the first extract)? The second extract suggests that consumption (household spending) and investment had slowed and there are concerns expressed about the housing market. the evidence in this extract was thought to be important and the committee voted to reduce the interest rate by 25 basis points (¼ of 1%) by 5 to 4 votes. In the second a decrease in interest rates will lead to excess aggregate demand. Are there any difficulties in coming to this conclusion? All the signs are not in the same direction. This may have led the Monetary Policy Committee to recommend reducing interest rates to prevent a further decline. incomes. Because of the conflicting evidence and difficulties in judging the timing of policy. This could be a sign of the economy recovering on its own (as the multiplier effect kicks in). which will increase output with only a small effect on inflation.. In the first case a decrease in interest rates will increase aggregate demand. . This would suggest diagram (a) is appropriate. output. for instance. If. However. This decrease in incomes leads to a further decrease in consumption. The extract states there were some signs of a pickup in consumer expenditure in the last quarter. which will increase output only in the short run and lead to a much larger effect on inflation (which is the main concern).how is it decided? 5 Feedback Task 2 Intermediate How do we relate the policy decision to the diagrams? In deciding its policy the Monetary Policy Committee has essentially to decide if the economy is in a situation as reflected in diagram (a). the change in interest rates is usually small. employment. [Historical note: the evidence present to the Monetary Policy Committee at this date was considerably wider than this extract. so that relatively small declines now may become larger in a few months’ time. etc.Problem Focused Exercise: Monetary Policy. There is a problem of time lags as the monetary policy may not begin to work until the economy has already recovered and then this just adds to inflation.] Feedback Task 1 (cont) Basic Copyright: Embedding Threshold Concepts Project 26/08/07 This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning. Which of the diagrams is appropriate here? They will try and judge whether interest rates are too high by looking for signs of what is happening in various markets. which is the multiplier effect. at an output (and employment) below that given by the long-run aggregate supply curve (LRAS) or as in (b) where output is already equal to or above that given by the long run aggregate supply curve. This in turn leads to a decrease in employment and incomes. What is the importance of the multiplier effect? Any change is magnified by the multiplier effect.

.Problem Focused Exercise: Monetary Policy. T re is a he multiplier effec t with the inc rease in consumption. in comes then increase as jobs are c reated and this inc reases consumption. Copyright: Embedding Threshold Concepts Project 26/08/07 This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning. Investment and exports increase. T here is a multiplier ef fec t with the increase in consumption. there is an inc rease in incomes and this increases c onsumption. Savings and imports fall.how is it decided? 6 Decreased Savings & Imports Circular Flow of Income T Rise in consumption G Increased Investment & Exports Households Firms Rise in income With an decrease in interest rates there is: •An inc reases in injec tions. •A reduc tion in withdrawals.

However. This decrease in incomes leads to a further decrease in consumption. etc. Given what is expected to happen to aggregate demand. There is a problem of time lags as the monetary policy may not begin to work until the economy has already recovered and then this just adds to inflation. This in turn leads to a decrease in employment and incomes. so that relatively small declines now may become larger in a few months’ time.Problem Focused Exercise: Monetary Policy. what should the MPC recommend? * a fall in interest rates Are there any difficulties in coming to this conclusion? However. interest rates affect aggregate demand (spending) in the economy. The committee will look for evidence for what is happening to aggregate demand – is it growing too slowly or too fast given the inflation objective? For the evidence they will look at the effects on individual markets that we identified in section 1. [Historical note: the evidence present to the Monetary Policy Committee at this date was considerably wider than this extract. which is the multiplier effect. output. . investment falls this will lead to a decrease in output..how is it decided? 7 Feedback Task 2 Basic As we saw above. the evidence in this extract was thought to be important and the committee voted to reduce the interest rate by 25 basis points (¼ of 1%) by 5 to 4 votes. employment. incomes. What does the extract suggest is happening? * consumption (household spending) had slowed (and hence saving was rising) * investment had slowed * uncertainty due to adjustments in the housing market What will these do to aggregate demand (spending)? * it will grow more slowly or decline What is the importance of the multiplier effect? Any change is magnified by the multiplier effect. all the signs are not in the same direction. This could be a sign of the economy recovering on its own (as the multiplier effect kicks in). for instance. If. The extract states there were some signs of a pickup in consumer expenditure in the last quarter. Because of the conflicting evidence and difficulties in judging the timing of policy.] Copyright: Embedding Threshold Concepts Project 26/08/07 This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning. the change in interest rates is usually small.

The tasks can be carried out on an individual basis but students may benefit from working in groups. . Sequencing and timing 1.how is it decided? 8 Notes for lecturers Objectives of the exercise and prerequisites Learning Focus: Understanding the monetary transmission mechanism and the factors that will influence the decisions of the Monetary Policy Committee on interest rates. 2. business students as well as those taking an economics award). economic modelling and cumulative causation. Threshold Concepts that are important are interactions between markets. Copyright: Embedding Threshold Concepts Project 26/08/07 This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.Problem Focused Exercise: Monetary Policy. or at different junctures in a module. In order to allow this exercise to be used with different groups of students (e.g. 4. 3. the feedback is available at two levels for you to choose: (a) for students who have only covered the circular flow of income and a general introduction to the idea of the multiplier (labelled basic). without allowing time for presentations. Students can be asked to give a presentation of their findings to encourage participation (this can be certain selected groups rather than all in order to fit the time scheduling). The exercise is likely to take 30.40 minutes. Task 1 is on the transmission mechanism and task 2 is on deciding the direction of monetary policy. It is possible to set task 1 without task 2. Prior Knowledge Required The students need to have been introduced to a model of the macroeconomy. 5. (b) for students who have covered the AD/AS model (labelled intermediate). Both tasks ask students to read an extract from the Bank of England and answer a series of questions. Feedback for task 1 should be given before students attempt task 2.

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