2.6.

2 Monetary Policy

POLICY INSTRUMENTS

Definition of Monetary Policy

Monetary policy involves using interest rates and other monetary tools such as
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________

In particular monetary policy aims to stabilise the economic cycle – keep inflation low
and stable and avoid recessions.
How does monetary policy work?

• UK monetary policy is set by

the________________________________________
____________________________________________

• They are ___________________________________________

in setting interest rates but have to try and meet
the ___________________________________________
___________________________________________.

• The Bank of England set the ________________________. This is the rate

commercial banks borrow from the Bank of England.

• Changing the base rate tends to influence all interest rates in the
economy – ______________________________________________________________

Monetary Policy Committee (MPC)

• The __________________________ has been independent of government

since 1997

• The Monetary Policy Committee (MPC) has nine

members, some of whom are appointed by the
government and some by the Bank of England. The
Governor of the Bank has the casting vote if there is
an equally split decision on interest rates

• Each month the MPC meets to consider the latest

news on the UK and global economy

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Tools of monetary policy:

(Exchange rate)

Interest rates

• The Bank of England studies inflationary trends in the economy. This

involves looking at a range of economic variables such as:

• Unemployment, consumer
confidence, spare capacity in the
economy, exchange rate index,
house prices, economic growth

• From these statistics, the Bank of

England decides whether inflation
is likely to rise or fall.

• If they expect higher inflation and higher growth, they will tend
to _______________________________________.

• If they expect lower growth and a fall in the inflation rate, they will
tend to _______________________________________.

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 Interest rates of Macro Objectives

Lowering interest rates causes:

• consumers/firms to borrow more, causing more C/I (more AD) and

___________________________________

• more spending/investment, causing firms to need more workers

___________________________________

• More spending on goods/services causing ____________________________

Money Supply & Quantitative Easing

The central bank can affect the money supply through its monetary policy -
Quantitative Easing
• buying bonds from private sector to increase the money supply
• During the credit crunch of 2008-09, the Bank of England also
used Quantitative Easing as a part of monetary policy.
• This involves creating money electronically to buy assets (such as
government bonds from banks). It is hoped by buying illiquid assets
there will be an increase in the money supply and avoid deflationary
pressures.

Money supply and Macro Objectives

Increasing the money supply causes:

• Banks willing to lend more causing more C/I (more AD) and
________________________________________

• more spending/investment, causing firms to need more workers

________________________________________

• More spending on goods/services causing_____________________________

Money Supply

An increase in the money supply will act as an injection into the circular flow of income. This

will encourage expenditure and increase AD leading to economic growth. However the OC of

this growth is that the increase in the supply of money will lead to a reduction in its value. A

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Money Supply QE

Expansionary monetary policy

• This involves ______________________________.

• Therefore the government will ______________________________interest

rates (r) and ______________________________ quantitative easing (QE)

• This will______________________________ borrowing costs to

consumers/firms and increases disposable income of consumers
with ______________________________

• This ____________________________________________________________________

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Liquidity trap
This is where low interest rates having
little impact on aggregate demand

_________________________________________

_________________________________________

If interest rates are near or at 0%, you

can’t lower them any more!

Advantages of Monetary Policy

• Evidence shows that, in normal conditions, ___________________________
______________________________________________________, which suggests
that UK consumers are highly interest rate elastic.
• The Bank of England’s Monetary Policy Committee is independent
from government and ___________________________________________________
__________________________________________________________________________.
• ___________________________________________________________________________
_______________________________, which contrasts with discretionary
fiscal policy which cannot be adjusted at such regular intervals.
• While the full effects of interest changes may not be experienced for
up to a year,
___________________________________________________________________________
_______________________________. The time-lag on output is estimated to
be around one year, and on the price level, around two years.

Disadvantages of Monetary Policy

• __________________________________________________________________________
– This occurs when a cut in interest rates fail to stimulate economic
activity. e.g. because of low confidence or banks don’t want to pass
base rate cut onto consumers.

• __________________________________________________________________________–
interest rates. For example, a rise in oil prices causes cost-push
inflation and lower growth. The Bank could increase interest rates
to reduce inflation, but, it would cause economic growth to fall as

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 well. In 2009, inflation rose to rising oil prices, but the economy was
also in recession; the Bank decided to ‘allow’ the temporary inflation
and concentrate on economic recovery.

• __________________________________________________________________________–
Tight monetary policy causes an appreciation in the exchange rate
which will make exports less competitive.

• __________________________________________________________________________–
e.g. higher interest rates increase the disposable income of people
with savings. But, could cause homeowners to be unable to afford
their mortgages.

• ___________________________- If the Bank of England change base rates,

it can take up to 18 months for the effects to filter through the
economy. For example, if people have a two-year fixed mortgage,
they will not notice until they remortgage. This means the Bank
needs to predict future inflation so that they can change interest
rates in anticipation.

IDO: Monetary Policy

• __________________________________________________________________________
If the multiplier effect is large, then changes in monetary tools will
have a bigger effect on overall demand.

• __________________________________________________________________________
Monetary policy is somewhat effective in a recession where fiscal
policy is insufficient to boost demand. In a deep recession monetary
policy may be inefficient (liquidity trap).

• __________________________________________________________________________
For example, if the government pursue expansionary monetary
policy, but government spending falls, and the global economy is in
a recession, it may be insufficient to boost demand.