Jottings

Jottings



Monetary Policy Questions

1. 1. Define the term ‘monetary policy’
• • Monetary policy is the macroeconomic policy controlled by the Bank of England. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
• 2. Who is responsible for setting the bank rate in the UK each month?
• • C The Monetary Policy Committee
• 3. Explain why monetary policy has become a more important policy for the government to achieve its macroeconomic objectives since 2009.
• • Since the economic crash/ recession it has become more important to try and stimulate growth for the UK economy, therefore, it has become a key aim for the government.
• • In a recession, cutting interest rates may prove insufficient to boost demand because banks don’t want to lend and consumers are too nervous to spend. Interest rates were cut from 5% to 0.5% in March 2009, but this didn’t solve recession in the UK but it has helped a certain degree to encourage growth and spending in the UK.
• 4. Explain how the role of the bank of England as a ‘lender of last resort’ allows it to influence interest rates in the UK.
• • As the bank of England can control the rate at which they lend money to the UK banks, it is possible for them to in a situation of last resort for a UK bank to make borrowing easier or harder for the bank and therefore, this helps it to influence interest rates of the UK banks as they will be set in accordance with the Bank of England’s so that the banks make profit, but also look competitive to consumers, if the bank puts the rates down then it is a lower interest rate caused by the Bank of England.
• • Lending long term and borrowing short term means that banks are unstable and a key role of a central bank is to maintain the stability of financial markets. One of the main ways in which they fulfil this function is by providing ‘liquidity insurance’, i.e. they act as ‘lender of last resort’ to the banks. However, this does not mean that the central bank will bail out a bank that has made bad investments and is making losses. Generally, the central bank will only act as lender of last resort to banks that are fundamentally sound but suffering from a temporary shortage of liquidity.
• • In the context of the UK economy, when the Bank of England acts as lender of last resort, it's lending to the banks is usually secured against high-quality assets. This means that the banks will only want to access emergency lending from the Bank of England if they can’t obtain the funds they need from elsewhere, e.g. by borrowing on the interbank market. A penal rate of interest, above Bank Rate, is charged for liquidity provided to a distressed bank.
• •http://www.bankofengland.co.uk/markets/Pages/sterlingoperations/liquidityinsurance.aspx
• 5. What of the following is most likely to be a consequence of a risk in the bank rate in the UK?
• • D A rise in the exchange rate
• 6. Explain 2 ways in which the bank rate might affect the level of consumption in the UK

• • Lower interest rates cuts the cost of paying the debt on a mortgage and increases the disposable income of households. In recent years, many central banks around the world have made a deep cut in interest rates in a bid to stimulate consumer demand. Official interest rates in the UK have been at 0.5% since March 2009 as a result.
• • The Supply of Credit affects the level of consumption as banks have become less willing to lend and if they do, the rate of interest on the loan has increased. Items such as mortgages have become harder to acquire and potential homebuyers now need to find a bigger deposit before getting a loan. Therefore, there has been a decrease in the supply of credit available for many households and businesses.

• 7. Explain how aggregate demand in the UK might be affected by a fall in the exchange rate of the pound?
• • A fall in the exchange rate will raise import prices, and assuming an elasticity of demand, import spending will fall. The combined effect is an increase in AD and an improvement in the UK balance of payments. As M is a negative component of AD.
• • A reduction in the exchange rate will reduce export prices, and, assuming demand is elastic, export revenue will increase. As X is a positive component of AD
• 8. The value of the pound sterling against the euro rises from £1 = € 1.05 to £1 = €1.25. Which of the following statements is true?
• • A The price of an imported Italian Car valued at €20,000 will fall to £16,000
• 9. Explain how a rise in the exchange rate of the pound might affect the ability of the UK government to meet its macroeconomic objectives.
• 10. Explain why monetary policy might be considered to have been successful since 2009
• • The key objectives for the UK are:
1. i. Stable low inflation - the Government’s inflation target is 2.0% for the consumer price index.
2. ii. Sustainable growth – growth of real gross domestic product – sustainable in keeping inflation low and reducing the environmental impact of growth.
3. iii. Improvements in productivity – this is designed to improve competitiveness and global trade performance
4. iv. High employment - the government wants to achieve an increased employment and eventually a situation where all those able and available can find meaningful work
5. v. Rising living standards and a fall in relative poverty – cutting child poverty and reducing pensioner poverty.
6. vi. Sound government finances - including control over state borrowing and the total national debt

A rise in the exchange rate may affect this as this would mean the currency buys more foreign exchange, therefore, imports are cheaper and exports are more expensive therefore there is imported deflation and, therefore, the price of imported good will go down, depreciation of the exchange rate is likely to cause inflation. However, if the aim is to keep inflation low them higher exchange rates will lead to a decrease in inflation to a controllable level.

Inflation is a factor of the exchange rate, if inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also foreign goods will be less competitive and so UK citizens will buy fewer imports. Therefore, countries with lower inflation rates tend to see an appreciation in the value of their currency.

Monetary Policy leads to Exports being more expensive. Therefore, the quantity of exports falls. Imports become cheaper. Therefore, the quantity of imports rises. Lower AD. Assuming demand is elastic, an appreciation will cause lower aggregate demand and lower economic growth. 

Lower inflation. This is due to: Lower import prices e.g. falling oil prices from the appreciation, Lower exports and lower AD, reducing demand pull inflation, To remain competitive, firms have a bigger incentive to cut costs. A Decline in exports and rise in the quantity of imports. Foreign direct investment may fall. A rise in the exchange rate may discourage foreign direct investment (FDI) because it is now more expensive for foreign firms to invest. 

This has been a success for the UK government as since the recession in 2008-09 it has offset the contractionary effects of the deep cuts in the level of government expenditure. Equally low-interest rates have helped to stimulate demand in the economy, as consumption has increased due to this, there is a time lag which is clear as real wages have risen only towards the end of 2014. It is estimated that the time lag is approximately 18 months between a change in monetary policy and the impact affecting aggregate demand. In 2014 investment in the UK was growing at an annual rate of 11% which is the fasted growing since 2007. Rising investment and strong consumption has helped to keep unemployment rates below the level expected by many economists during and following the recession.