Transcript 15.1_MonetaryPolicy - econbus

AS Economics
Monetary Policy
The Bank
The Bank of England
What is monetary policy?
Your task
Question
Definition
Inflation is
A
The manipulation of interest rates and the
money supply in order to manipulate
the level of aggregate demand.
Monetary policy is
B
The cost of borrowing money.
The interest rate is
C
A sustained rise in the general price level.
The Consumer Price Index D
is
A sustained fall in the general price level.
Deflation is
E
The average household cost of living
excluding housing costs.
Demand-side policies are
F
Monetary and fiscal policies designed to
manipulate the level of aggregate
demand.
Answers
Question
Answer
Inflation is
A sustained rise in the general price level.
Monetary policy is
The manipulation of interest rates and the
money supply in order to manipulate the
level of aggregate demand.
The interest rate is
The cost of borrowing money.
The Consumer Price Index is The average household cost of living
excluding housing costs.
Deflation is
A sustained fall in the general price level.
Demand-side policies are
Monetary and fiscal policies designed to
manipulate the level of aggregate
demand.
Key Issues
• To understand monetary
policy issues.
• To understand how
monetary policy is used to
control inflation.
• To appreciate the main
effects of changes in
interest rates.
• To know recent trends in UK
interest rates
• To be aware of the level of
The aim of monetary policy
The main aim of
monetary policy is
to help keep
macroeconomic
stability in the
economy and
also to maintain
the value of
money – i.e.
achieve price
stability
The instruments of monetary policy
• Monetary policy involves the use of interest
rates and other instruments of policy to
control
– The growth of AD (C+I+G+X-M) relative to the
economy’s productive potential
– The demand for and supply of money and credit
– To occasionally influence the value of the exchange
rate
New ‘in’ term …
Quantitative easing!
mortgages
savers
In debt
How does a
fall in
Interest rates
effect different
sectors of the
economy?
Credit
Card
holders
spenders
Pensioners
What is Monetary Policy?
• Since 1997 monetary policy has been in the hands
of the Bank of England
• Currently monetary policy concerns changes in
short term base interest rates
– The main objective of monetary policy is price
stability
– Monetary policy seeks to influences AD – it has
little direct impact on LRAS
– The Government sets the inflation target
Monetary Policy Committee
• Main objective for the Bank of England:
– Meet the inflation target: Inflation of 2.0%
– Monetary policy is designed to be preemptive (forward-looking) i.e. raise interest
rates before inflation accelerates, or cut interest
rates to avoid an inflation under-shoot /
economic recession
• Changes in official interest rates filter their way
through the rest of the UK financial system (e.g.
savings rates and mortgage rates.
Reading the macroeconomic tea-leaves
When making decisions on whether or not to change interest rates, the
monetary policy committee will consider many economic factors
Economic conditions in the UK economy
Trends and fluctuations in the European and global economy
This involves a detailed look at what is happening and what it might mean
for inflation
the MPC
announce changes
in IR on the first
Thursday of every
month at 12 noon!
Members….
• 9 members
• Governor
• 2 Deputies
• 2 Bank executive directors
• 4 govt appointed members
Setting Rates – The Economic
Assessment
• Demand-side factors
Supply-side factors
• Real GDP growth
• Wages and earnings
• Estimate of the output gap
• Labour Shortages
• Consumer spending
• Net Exports (Trade)
• Government spending
• House Prices
• Unemployment
• Consumer borrowing
• Business & Consumer
Confidence
• Import prices
• Commodity prices (e.g. oil)
• International Factors
• Sterling Exchange Rate
• Global Inflation Trends
Vital
theory!
Prioritise activity
• Which 3 factors do you consider to be THE MOST
important factors for keeping IR’s low in UK?
MPC Meetings
• The MPC considers the macro-economic background
• They assess a broad range of economic indicators
– Is aggregate demand too strong?
– Are there inflation signals from the labour market?
– Is there a risk of inflation from import prices?
– How will exchange rate changes affect costs and
prices
S.P.I.C.E.D.
An Inflationary Gap
Price level
LRAS
Above full-employment
equilibrium
Inflationary
Gap
What type
of inflation
is this?
SRAS
AD
Real National Output
How could
the BoE use
IR’s to
manage this?
How could the
Govt use fiscal
policies to
manage this?
Base Interest Rates – The Long Run Picture
Still at
0.5%
• IR’s effecting mortgage
holders
• IR’s winners and losers
The effects of interest rate changes
Changes in interest rates
affect virtually every part of the
economy – from homeowners
with a mortgage, to business
confidence, to the exchange
rate and the prospects of UK
exporting businesses
Transmission Mechanism…. What would happen
if IR’s rise?
Transmission Mechanism if IR’s rise
One side
WINNERS
Other side
Losers…
LOW… interest rates: Winners or Losers?
• A homeowner with a mortgage of £250,000
• A pensioner couple who have paid off their
mortgage and have a good level of savings in a
building society account
• A travel agent, 70 per cent of the holidays they sell
are to British consumers to overseas destinations
• A manufacturer of kitchen units in the West
Midland with a high level of bank loans
• A builder who specialises in home improvements.
How Monetary Policy affects AD
Mapping out the
transmission mechanism – the effects of changes in interest rates
Market interest rates
E.g. savings rates & credit cards
Asset prices
E.g. house prices
Domestic
Demand
I.e. C + I + G
Aggregate
Demand
AD
Drives short-term
economic
growth
Official Interest
Rate
Set by the MPC
Expectations and
Confidence
Businesses & consumers
Net
External
Demand
i.e. X - M
Domestic
Inflationary
Pressure
i.e. changes
in the output gap
(actual GDP relative
to potential GDP)
Import
Prices
Consumer Price
Inflation
Exchange rate
Channels of Monetary Policy
INTEREST
RATE
CHANNEL
Expansionary
Monetary Policy
Lower Interest
Rates
Stimulate
Investment
Spending
Increase in
Economic Activity
BANK
LENDING
CHANNEL
Expansionary
Monetary Policy
Increase in Bank
Loans
Stimulate
Consumer
Spending
Increase in
Economic Activity
EXCHANGE
RATE
CHANNEL
Expansionary
Monetary Policy
Exchange Rate
Depreciation
Stimulate Exports
Increase in
Economic Activity
WEALTH
EFFECT
CHANNEL
Expansionary
Monetary Policy
Rise in Equity
Prices
Rise in Value of
Financial Wealth
Increase in
Economic Activity
Rise in Land and
House Prices
Interest rates and effective disposable income
Effective disposable
income = post tax
income after the
effects of mortgage
interest repayments
So a rise in interest
rates will (other things
remaining the same)
lead to a fall in the
effective disposable
income of
homeowners
Will there ever be 0% IR?
• http://news.bbc.co.uk/1/hi/business/7791425.stm
• To what extent will 0% interest rates help an
economy out of a recession?
Note:
2008 news article
Limits to the Impact of Rate Changes
• Some factors may dampen the impact of rate changes:
– (1) Mortgage interest rates do not always follow
base rate change
– (2) Many home-owners are on fixed rate mortgages
– (3) People in rented property see no direct effects
from changes
– (4) Credit-card lenders may not change rates
immediately
Evaluation
issues
Limits to the Impact of Rate Changes
– (5) If businesses are operating with spare capacity,
a fall in rates will not necessarily lead to higher
planned capital investment
– (6) Many sources of funding for capital spending
(e.g. loans and debentures) are at fixed rates of
interest
– (7) Lower interest rates causes a fall in the effective
disposable income of millions of people with net
savings
AS Economics
White board activity
On one side write Monetary
Monetary Policy
and on the other Fiscal
You decide – is it monetary or fiscal?
• A cut in corporation tax
• A restriction on bank lending
Now decide will each
of these policies
REFLATE / EXPAND
or
DEFLATE /
CONTRACT
• A reduction in the budget deficit
• An increase in govt subsidies
• An increase in interest rates
the economy?
BoE & Govt dilemma
• Why if IR’s are being reduced so much – is our AD
/ GDP not expanding?
• Why are consumers & businesses not spending
any more?
• Are the high street banks willing to lend at 0.5%?
• Why not?
• How can interest rates be used to control demand
pull inflation?
• Draw a Demand pull inflation diagram
• How can IR’s influence AD?
• Can IR’s influence LRAS?
HOMEWORK
Next lesson
• Return of BoP past paper work
• Review of Budget
• Exam revision – another past paper review