Transcript Monetary-Policy

Macroeconomic policies
Government macroeconomic policies
In order to achieve its objectives, the government uses
2 main types of policies:
• Demand-side policies
– Policies to influence aggregate demand in order to achieve
objectives
• Monetary policy
• Fiscal policy
• Supply-side policies
– Policies to influence long run aggregate supply (to increase
it)
Monetary policy
In general, monetary policy is the manipulation by a government of
monetary variables such as interest rates and the money supply to
achieve its objectives
•(In the UK) monetary policy is the manipulation of interest rates, and
the use of quantitative easing, to influence aggregate demand in order
to achieve price stability. Subject to this, monetary policy supports the
Government’s other economic objectives
– Price stability is defined by the Government’s inflation target of 2% measured
using CPI
– As we have just looked at, price stability is important in providing the right
conditions for sustainable growth in output and employment
•In the UK, monetary policy is conducted by the Bank of England,
which is independent
How monetary policy operates in the UK
• The principal way monetary policy
works is through changing interest
rates in order to influence aggregate
demand
– When demand exceeds supply, inflation
tends to rise above the 2% target, and
so the Bank raises interest rates to
reduce AD.
– The interest it changes is called the
base rate, which is a short term interest
rate. As a result, commercial banks
(HSBC, NatWest etc) raise their interest
rates
– On the other hand, when supply
exceeds demand, inflation tends to fall
below the Bank’s 2% target, and so the
Bank reduces interest rates to
stimulate AD
Price
Level
LRAS
SRAS
P
AD
0
Yf
Economic Effects of Interest Rate Changes
A less certain effect. Higher interest rates
increases the cost of mortgages, which
reduces the demand for houses. House
prices might fall so wealth effect so C↓
and AD↓. Fewer people moving house
means lower demand for house-related
products (no replacement kitchens,
redecoration etc), so C↓ and AD↓
Higher interest rates makes it more attractive
to save money in UK bank accounts, which
means higher demand for £, so £ rises, so X↓
and M↑ which means AD falls. These money
flows are called hot money
Exchange Rate
Higher interest rates means demand
for loans falls as households will
borrow less to buy consumer durables
like cars, so C↓ and AD ↓
Housing Market
Examiner favourite when interest rates
are falling if interest rates are cut,
many homeowners may increase the
mortgage (loan) on their house, and
spend this. So leading to C↑ and thus
AD↑
Investment
Higher interest rates increases the cost
of borrowing for firms in order to buy
capital equipment, which means
investing in capital stock is less
worthwhile, so I↓ and AD ↓
Credit Demand
Interest Rate Changes
Will Impact:
Saving
Higher interest rates means savings are
more worthwhile, so households save
more which means so C↓ and AD ↓
How quickly does monetary policy work
• If AD is too strong (AD2), which means inflation
will be rising, the Bank of England will raise
interest rates in order to reduce aggregate
demand
• How quickly will AD fall?
• There are time lags. Whilst the impact will
start quickly, it takes up to two years for
effects to be fully realised in the economy, so
the Bank of England has to estimate what
inflation will be in 1-2 years time. The time lags
to consider:
– How long after Bank of England changes rates
before market interest rates change eg mortgage
rates?
– How long before consumers save more, spend
less?
– How long before this means firms reduce output
and make staff redundant?
Price
Level
LRAS
SRAS
AD2
0
Yf
Quantitative Easing (QE)
• After the financial crisis of 2008, central banks cut interest rates to virtually
0 (0.5% in the UK), yet aggregate demand did not recover sufficiently
• Conventional monetary policy was therefore ineffective
– Interest rates could not easily be cut further
– Lower interest rates were not stimulating extra demand - perhaps consumers
and firms were not confident, and therefore did not spend more as interest
rates were cut
• As a result, central banks, including in the US and UK introduced an
unconventional form of monetary policy called quantitative easing (QE)
• Quantitative easing is where a central bank creates new money
electronically to buy financial assets, like government bonds. This process
aims to directly increase private sector spending in the economy and
return inflation to target
How QE works – bond primer
• Bonds are issued by firms or the government in order to borrow money. These bonds
are bought by investors, eg pension funds (investors in this case means investing money
not buying machinery). The government issues bonds to finance the budget deficit
• When the government issues a bond, it promise to pay a certain fixed cash amount
each year to the ‘investor’ who buys the bond, and then to repay the original amount
borrowed sometime in the future
• For example, the government may issue £100m bonds to investors (so borrowing
£100m). For each £100 held, the government may pay eg £4 income
• In this case, the rate of interest, or yield, the investor receives is 4% (£4 each year for an
investment of £100)
• Government bonds can be bought or sold on bond markets, and so prices can go up or
down. If demand for bonds rises, then the price of a bond rises, which means the
interest rate, or yield, falls:
– For example, if the price of this bond rises to £120, an investor buying this bond in the market will receive £4
a year. This is a yield of 3.33% (£4 each year for an investment of £120)
How QE works – the works!
• The Bank of England buys bonds from private sector financial firms, such as
pension funds, using money it has created electronically (it credits the seller’s
account). Creating money increases the money supply. QE has 3 main effects:
– The price of these bonds increases. This means yields fall which means interest rates fall, which
can stimulate both investment and consumption (Advanced: this affects longer term interest
rates which conventional policy of changing the base rate does not)
– Investors have received money from the Bank of England, and will then buy other financial
instruments such as shares. This means asset prices in general increase, which means an
increase in wealth. The increase in wealth will encourage consumers to spend more
– There will be an increase in the money supply. This is because there will be an increase in
deposits at banks, which means banks will be able to lend more money to firms and households,
so investment and consumption may increase. Evaluation: does not mean they will lend more
• To date QE has totalled £375bn, £325bn of which has been government bonds.
• Has QE worked?
– Since the financial crisis, banks have not been very willing to lend, and so this part was not
effective. Overall though, QE has probably meant GDP was higher than without QE so yes it
has worked
Monetary Policy Committee
• In the UK, monetary policy is decided by the Bank of England’s Monetary Policy
Committee (MPC), which is independent from Government. David Cameron and
George Osborne cannot tell the Bank of England to change interest rates
• The MPC has 9 members
– Governor Mark Carney plus 4 from the Bank of England (including 2 Deputy Governors)
– 4 external members appointed by the Chancellor
• The MPC votes each month on whether to change interest rates or QE in order to
meet the mandate from the Chancellor of the Exchequer, which is inflation of 2%
• Economic data is considered to assess the potential of each indicator to impact
inflation
• The MPC has to consider this data, and make a judgement about what inflation is
likely to be in 1-2 years time if they do not change policy
– If they think it will be above 2% and rising, then they will tighten policy – raise interest rates
– It they think it will be below 2% and falling, they will loosen policy – lower interest rates or increase QE
• The Governor writes a letter to the Chancellor if inflation is 1% below, or 1% above
target (below 1%, above 3%)
MPC setting the interest rate…
Exchange Rate
Rate of GDP Growth
Wage Inflation
Housing Market
Credit Demand
Economic Data
for Consideration
Unemployment
Investment
Manufacturing Output
Retail Sales
MPC must consider all these things in the economy to assess the inflationary
pressure that is likely – decide whether they need to change interest rates to
achieve 2% inflation target.
Economic
indicator
How it will affect inflationary expectations…
Investment
If it is rising, then this will increase AD in the short run, causing Demand-Pull inflation. (In the longer
term, it might lower production costs through greater efficiency reducing inflation again if AS shifts out)
If it is falling then…
Unemployment
If it is rising, then…
If it is falling then…
Housing
Market
If it is rising, then…
Rate of GDP
Growth
If it is high, then…
Exchange Rate
If it is rising, then…
If it is falling then…
If it is low then…
If it is falling then…
Wage Inflation
If it is high, then…
If it is low then…
Credit Demand
If it is rising, then…
If it is falling then…
Manufacturing
Output
If it is rising, then…
Retail Sales
If it is rising, then…
If it is falling then…
If it is falling then…
Criticisms of Monetary Policy
• Difficult to assess state of the economy based on monthly data, so
the wrong decision might be taken
• Time lags – takes up to two years for effects to be fully realised in
the economy, so the Bank of England has to estimate what inflation
will be in 1-2 years time. They might get this wrong
• Related to time lags, global economic conditions may change rapidly
and unexpectedly. For example, a collapse or surge in oil prices, or a
collapse in the Chinese economy
• Low interest rates may not be effective in stimulating demand when
firms and consumers are not confident about the future
• Quantitative easing is not proven. Some economists think it has
worked (including those from the Bank of England), some think not