Monetary Policy

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Monetary policy involves the changes in interest rates, supply of money, and credit and exchange rates to influence the economy

The policy influences the decisions we make about how much we save, spend and borrow

The Monetary policy decisions made by central banks who operate monetary policy can have a powerful effect on consumers/businesses as well as the macroeconomic indicators

Changes in the interest rates have demand and supply side effects

Important aspects of monetary policy include:

Market interest

Bank Lending

Currency Markets

Inflation targets

BoFE

European Central Bank

Interest rate is a reward for saving and a cost for borrowing- expressed as %

There are various types of interest rates, including borrowing interest rates, bank interest rates, mortgage interest rates and credit card interest rates.

The real rate of interest is the money rate of interest rate- rate of inflation

In May 1997, the Bank of England became independent of the government

How is the Monetary policy managed?

The MPC make judgments in what the approximate levels of policy interest rates for UK economy are

Inflation target rate is at 2%- with the allowance to vary 1% either side of the target

The Main Roles of the Central bank are to:

Keep Monetary Stability

This includes ensuring stable prices and confidence in currency, having to control the inflation close to level set by the government

Keep Financial Stability

- This includes overseeing the financial system to ensure an efficient flow of savings, loans, and confidence in financial intermediaries. If financial stability breaks then this could be damaging economically and socially

What do the Bank of England consider when they are setting interest rates?

Rate of GDP growth and the size of the output gap

- This is due to the MPC wanting AD to grow inline with a countries productive potential

The amount of Bank lending and Consumer credit figures

Share prices and house prices

- Used to determine household wealth

Consumer/ Business Confidence

Growth in wages, earnings and unit labour costs

- looking out for cost push inflation

Unemployment figures

Trends occurring in global foreign exchange rates

International Data

Ultimately the MPC consider lots of indicators before deciding on an interest rate level

They make a judgement about what this indicates about inflationary pressures- over 2 year forecast horizon

The reason why the MPC consider 2 years is because the interest rates would have a time lag, therefore wouldnt come into effect on AD and prices for around 2 years.

Forward Guidance was introduced by Mark Carney in 2013

It has. been signalled that Bank of England will leave interest rates unchanged as long as unemployment level is below 7% and inflation is under control, with the effect of building confidence

Transmission mechanic of monetary policy

1) Change in interest rates

2) Impact on demand

3) Effect on output, jobs and investment

4)Real GDP and price inflation

It takes between 12 months and 24 months for full effect on Real GDP and inflation rate after change in policy interest rates

In macroeconomics the ceteris paribus assumption rarely applies as there are other external factors, changes in fiscal policy, changes in world oil prices.

There are several ways in which changes in interest rates influence AD, output and prices, which are collectively known as the transmission mechanism of monetary policy

MPC- influence AD/ inflation via lending and borrowing rates charged in financial markets

If the base interest rate increases, commercial banks/ building societies increase how much interest they charge on loans and interest offered on savings

The increase in interest rates discourages businesses from taking out loans to finance investment and encourages consumers to save which depresses AD/

A big influence is the amount of confidence

What do changes in the interest rates affect?

Housing Market and House Prices

- High interest rates increase cost of mortgages and reduce demand for housing

Effective disposable income of mortgage payers

-if interest rates increase, income of homeowners with a variable- rate mortgage, there disposable income decrease in PP

Disposable income of savers

-rise in interest rates boosts disposable income of those who paid of their mortgage, and the ones who have positive savings in the bank

Consumer demand for credit

-High Interest rates increase cost of paying debt on credit cards leading to deceleration in retail sales

Business capital investment

- Firms can take in account the actual/ expected level of interest rates in decisions. If there is a rise in interest rates, this may dampen their confidence and lead to a reduction in capital investment

Consumer/ Business Confidence

- Depends on prevailing economic conditions, where incurred in recession interest rates being cut will boost confidence. However cut in interest rates may signify the wider economy is in difficulty, and hard times lie ahead.

interest Rates& Exchange Rate

- Higher interest rates- may lead to appreciation of the exchange rate especially if UK interest rate is high in comparison to Euro Zone and US dollar, due to hot flows of money.

Strong Exchange Rate, will reduce competitiveness of UK as exports are more expensive- leading to deficit

Reduction in interest rates, with an increase in money supply and credit in an economy is an expansionary monetary policy/reflationary

Increase in interest rates, attempt to control or reduce the money supply of money, contractionary monetary policy/deflationary

Changing interest rates doesn't have a uniform impact on the economy

Some industries are more affected than others, such as exports linked industries, and industries connected to the housing market.

Depends on whether the demand of the industry is elastic, if elastic more impact

Quantitive Easing

When the policy of interest rates at zero/close to zero, there is. limit to the MPC conventional use

2009- Bank of England the policy of QE was used for the first time

The aim of QE is to support AD & stop a recession become a depression

QE is used in a way where it increases the supply of money in the banking system

The money is used to buy government bonds

However, there are doubts over the effectiveness of QE as the amount of lending has struggled to recover since the end of the recession

In 2015, total level of QE was 375BN

In theory this is how QE is meant to work:

Central bank creates money electronically adding money to balance sheet

Money is used to buy financial assets which are mostly government bonds

More demand leads to higher prices for assess- rise in price of bonds leads to lower yield in government bonds

Feed through to fall in long term interest rates

Lower interest rates and increased cash in banking system should stimulate the economy.

Low interest rates impact on distribution of income and wealth

Real income of savers

-If rate of interest paid of savings fall below level of inflation- positive net savings will reduce

Disposable income of mortgage payers

-Depends if mortgage is variable rate/ fixed rate

- If interest rate fall, income of home owners who have variable income will have an increased disposable income

When the cost of a mortgage falls,the demand for housing will drive property prices higher

This increases the wealth of those who own property but makes difficult for lower income families to buy a house

Policy interest rate (base rate) set each month by MPC- policy rates cut to 0.25% in summer of 2016

Expansionary monetary policy

Fall in nominal & real level of interest rates

Measures to expand supply of credit

Depreciation of external value of exchange rate

Deflationary Monetary policy

Higher interest Raes are both loans and savings

Tightening of credit supply

Appreciation of Exchange rate

Era of Ultra- Low interest rates

Central banks in many advanced countries have made extraordinary use of expansionary monetary policy

Policy interest rates approaching the zero bound

Negative policy rates in Sweden, Japan and Switzerland

Huge Rise in scale of QE

Increased use of exchange rate intervention as instrument of monetary policy

Negative policy interest rates designed to:

get commercial banks to lend

bring about reduction in real interest rates- which may stimulate business investment

designed to partly cause an outflow of hot money- which depreciates exchange rate

main aim is to lower risks to output, profits, employment or wages from deflation

What are the risks of negative interest rates?

can lower bank profitability by narrowing interest rates margins between savings and low rates

can cause banks to take excessive risks in search of higher returns

lower interest rates on deposits may cause business/ household to hoard cash rather than spend/ invest

pension/insurance companies may struggle to meet long term liabilities

economy may become dependent upon ultra- low interest rates- fiscal policy may be better

Keynesian thinks monetary policy ineffective

Is monetary policy in developed countries become less effective?

Impact of price deflation:

-HIgher real level or private/public sector debt

-Higher real interest rates on loans

-Weaker consumer/business confidence

Fall out for global financial crisis taken long to work through

Banks risk averse- less willing to lend favourably

Persistent high budget deficit0 promoted fiscal austerity

Advances countries could be suffering from liquidity trap

Keynesian Liquidity Trap

Occurs when low interest rates and high amount if cash balance in the economy fail to stimulate AD

Nominal circumstances