6.2 MONETARY POLICY
This video is relevant for this section despite it saying that it is for AQA.
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Monetary policy is the process by which a monetary authority of a country controls the supply of money and interest rates to ensure price stability and trust in the currency.
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In the UK monetary policy is carried out by the Bank of England and they have an objective set by the government to make sure inflation CPI is 2% +/- 1. The Bank of England is an independent monetary authority and the government has no control over it apart from setting the inflation target.
The most common tool of monetary policy is changing the interest rate. However, they also have other tools at their disposal such as quantitative easing, which the Bank of England used in response to the financial crisis. Monetary policy has a lag before a change has an effect in the economy. This lag is between 18 and 24 months. This is why before monetary policy is set the authority tries to predict where inflation will be in 18 to 24 months. If they predict that it will be too high or too low then they need to change their policy. The authority looks at a variety of different variables such as unemployment, consumer confidence, exchange rate index, economic growth, house prices, level of private debt, investment etc…
The most common tool of monetary policy is changing the interest rate. However, they also have other tools at their disposal such as quantitative easing, which the Bank of England used in response to the financial crisis. Monetary policy has a lag before a change has an effect in the economy. This lag is between 18 and 24 months. This is why before monetary policy is set the authority tries to predict where inflation will be in 18 to 24 months. If they predict that it will be too high or too low then they need to change their policy. The authority looks at a variety of different variables such as unemployment, consumer confidence, exchange rate index, economic growth, house prices, level of private debt, investment etc…
A Rise in Interest Rates
Interest rate changes have influenced aggregate demand. An increase in interest rate would have these effects on:
Interest rate changes have influenced aggregate demand. An increase in interest rate would have these effects on:
- Consumption – would fall. An increase in interest rates makes consumption in the present period relative costly in comparison to the future. This means that consumers may choose to save rather than consume. Also, individuals who have a low income may choose to borrow now for consumption and pay this back in the future. A rise in interest makes this more expensive and this puts consumers off, so consumption falls for potential borrowers. In addition, an interest rate rise makes the interest repayment more expensive for existing borrowers and this reduces their disposable income, which reduces consumption.
- Investment – would fall. Higher interest rates increase the cost of investment. As the cost has increased, firms are deterred from investing in new projects so investment falls.
- Government – unsure. Government expenditure may or may not change in response to a rise in interest rates. If interest rates rise, it may make it more expensive for governments to borrow because investors will place their money in bank accounts rather than in government bonds, as the interest on bank accounts has increased. Because of this the Government may have to increase the interest that they are paying on government bonds. This increased interest payments for the government may cause the government to reduce their expenditure if they wish to balance their budget. Alternatively, the government could just borrow more to fund their consumption.
- Exports – fall. A rise in interest rates causes money to rush into a country as the reward for cash (interest is higher). This increase in demand causes the exchange rate to rise. If the exchange rate rises, their goods are relatively more expensive and this causes exports to fall.
- Imports – rise. As higher interest rates cause the exchange rate to rise, this makes foreign goods relatively cheaper and this increases the amount of imports.
Decrease in Interest rate
A decrease in interest would have the opposite effect.
A decrease in interest would have the opposite effect.
- Consumption – rise.
- Investment – rise.
- Government – unsure.
- Exports – rise.
- Imports – fall.
Monetary Responce
If a monetary authority believes that inflation in 18 to 24 months will be above 2% because the economy is starting to overheat, they may choose to adopt a tight/ contractionary monetary policy, such as raising interest rates.
If the monetary authority believes that inflation will become too low then they will adopt lose/ expansionary monetary policy whereby they lower interest rates. After the financial crisis, the Bank of England lowered interest rates to try and stimulate the economy as they believed that with such a lack of demand inflation could be below 2% and may even turn into deflation. Before the financial crisis the Bank of England’s base rate was around 5% but as soon as the financial crisis hit they dropped the base rate gradually down to 0.5% where it has stayed ever since. Other central banks across the world did the same (European Central Bank and the Federal Reserve in America).
If a monetary authority believes that inflation in 18 to 24 months will be above 2% because the economy is starting to overheat, they may choose to adopt a tight/ contractionary monetary policy, such as raising interest rates.
If the monetary authority believes that inflation will become too low then they will adopt lose/ expansionary monetary policy whereby they lower interest rates. After the financial crisis, the Bank of England lowered interest rates to try and stimulate the economy as they believed that with such a lack of demand inflation could be below 2% and may even turn into deflation. Before the financial crisis the Bank of England’s base rate was around 5% but as soon as the financial crisis hit they dropped the base rate gradually down to 0.5% where it has stayed ever since. Other central banks across the world did the same (European Central Bank and the Federal Reserve in America).
Unconventional Monetary Policy
The Bank of England strayed from conventional monetary policy during the recent financial crisis. They chose to carry out quantitative easing, whereby the Bank of England created new money (which will be paid back in the future) and bought financial assets, such as government bonds, from financial institutions (banks). This was in the hope that as banks would now have more money they would be encouraged to lend it out to consumers and businesses, which would then stimulate demand in the economy. This was because despite interest rates falling, banks were reluctant to lend to consumers and businesses.
The Bank of England strayed from conventional monetary policy during the recent financial crisis. They chose to carry out quantitative easing, whereby the Bank of England created new money (which will be paid back in the future) and bought financial assets, such as government bonds, from financial institutions (banks). This was in the hope that as banks would now have more money they would be encouraged to lend it out to consumers and businesses, which would then stimulate demand in the economy. This was because despite interest rates falling, banks were reluctant to lend to consumers and businesses.
Credit
The Bank of England can control the amount of credit that banks can give out. They have recently brought in a policy stating that only 15% of mortgage approvals can be of values above 4 times their income. This is in an attempt to control the level of private debt, which grew during the 2000’s and was one of, if not the main cause of, the financial crisis.
The Bank of England can control the amount of credit that banks can give out. They have recently brought in a policy stating that only 15% of mortgage approvals can be of values above 4 times their income. This is in an attempt to control the level of private debt, which grew during the 2000’s and was one of, if not the main cause of, the financial crisis.