Monetary Policy

Functions of money Characteristics of money

Medium of exchange

Store of value

Measure of value

Standard of deferred payment

Acceptable

Portable

Durable

Divisible

Limited in supply

Difficult to forge

Types of Money

Notes Deposits Near Money

Narrow (M0) – Broad (M4) Liquid – less liquid

What is the money supply?

Monetarist theory on money supply (briefly) Increase in the money supply will cause inflation MV=PQ (Fisher Equation) (M = money supply; V = velocity of circulation; P= average price level; Q= quantity of goods and services sold)

𝑃 = 𝑀𝑉

𝑄

V & Q remain relatively constant

Therefore if M = P

Keynesian theory on money supply (briefly) Increases in money supply will not always be inflationary as V and Q not always constant. Liquidity trap may prevent money flowing e.g. banks hoarding cash (QE since 2008)

Monetary Policy

The manipulation by government of monetary variables such as interest rates and the money supply to achieve its objectives

Monetary Policy Committee

The Monetary Policy Committee (MPC) is tasked with setting the official Bank Rate as well as implementing a range of monetary policies such as quantitative easing. This is for the Bank of England’s own market transactions with financial institutions – i.e. the rate at which the BoE will make short-term loans to banks and other financial institutions. Changes in the official Bank Rate tend to affect the whole range of interest rates set by commercial banks, building societies and other financial institutions for their own savers and borrowers.

Nine members of the MPC including the Governor, the three Deputy Governors for Monetary Policy, Financial Stability and Markets and Banking, the BoE’s Chief Economist and four external members appointed directly by the Chancellor. A representative from HM Treasury also sits with the MPC at its meetings. The Treasury representative can discuss policy issues, but is not allowed to vote. They are there to make sure that the MPC is fully briefed on fiscal policy developments and other aspects of the Government's economic policies, and that the Chancellor is kept fully informed about monetary policy.

The Monetary Policy Committee (MPC) currently meets eight times a year for three days to interpret data, consider policy and set the interest rate. At the end the Governor puts to the meeting the policy that he believes will command a majority and members of the MPC vote. Any member in a minority is asked to say what level of interest rates they would have preferred. If there is an even split

between the MPC members present, the Governor has the casting vote.

The Monetary Transmission Mechanism

Interest rate is the price of money

Increase in Interest Rates (Contractionary Monetary Policy)

Decrease in Interest Rates (Expansionary Monetary Policy)

Less inflationary pressure

Negative impact on BOP in short run Lower economic growth More unemployment

Economic growth Less unemployment Improved BOP

Inflationary pressure

Keynesian

Classical

Keynesian

Classical

Impact on House Prices (Wealth effect)

1. Borrowing more expensive 2. Most houses purchased with mortgage 3. Less individuals able to afford to purchase new

or upgrade house due to increased cost of borrowing

4. Demand for housing falls 5. House prices fall or at least there is less upward

pressure on prices (micro) 6. AD falls as there is less demand for new houses

to be built (↓I), less demand for consumer durables (↓C), less borrowing or release of equity (↓C)

7. AD falls

1. Borrowing cheaper 2. Most houses purchased with mortgage 3. More individuals able to afford to purchase

new or upgrade house due to reduced cost of borrowing

4. Demand for housing increases 5. House prices increase or at least there is

upward pressure on prices (micro) 6. AD increases as there is more demand for new

houses to be built (↑I), more demand for consumer durables (↑C), more borrowing or release of equity (↑C)

7. AD increases

Impact on Saving (C&I)

1. Saving offers a greater return 1. Saving offers a smaller return 2. Opportunity cost for individuals spending falls

as does opportunity cost for firms investing.

2. Opportunity cost for individuals spending increases as does opportunity cost for firms investing.

3. Individuals choose to save instead of consume and firms choose to save instead of invest.

4. AD as ↓I and ↓C

3. Individuals choose to spend instead of save and firms choose to invest instead of save.

4. AD as ↑C and ↑I

Impact on Borrowing for consumer durables (C)

1. Many consumer durables bought on credit 2. An increase in interest rate increases the cost

of borrowing 3. This increases monthly repayments which will

mean less people can afford to borrow to make the purchase.

4. C↓

5. AD

1. Many consumer durables bought on credit 2. A decrease in interest rate increases the cost of

borrowing 3. This decreases monthly repayments which will

mean more people can afford to borrow to make the purchase.

4. C↑ (in turn may lead to ↑I) 5. AD↑

Impact on Discretionary Income (C&I)

1. Discretionary income falls as repayments on new loans and mortgages and repayments on variable rate loans increase.

2. C↓ 3. AD

1. Discretionary income increases as repayments on new loans and mortgages and repayments on variable rate loans fall.

2. C↑ (in turn may lead to ↑I) 3. AD↑

Impact on Exchange Rates (X-M)

1. Makes saving in UK more attractive to foreign savers. ‘Hot money flows’ in.

2. Demand for £ 3. Appreciation of currency 4. SPICEE

5. (X-M)

6. AD

1. Makes saving in UK less attractive to foreign savers. ‘Hot money flows’ out.

2. Supply of £s 3. Depreciation of currency 4. WPECIE

5. (X-M) 6. AD

Wealth Effect

1. Asset prices stall or fall 2. Saving becomes more attractive 3. Less confidence as less wealth

4. C

5. AD

1. House prices up (see above) 2. Other asset prices up e.g. shares and gov bonds

as people switch from savings 3. Increased confidence as more wealth 4. C↑ 5. ↑ AD

In evaluation:

Its effectiveness depends on other factors e.g. confidence, availability of borrowing

Its effectiveness depends on size of the change in interest rate, the more significant the change the more significant the impact

Original rate of interest

Time lag 12-24 months

Size of the multiplier (Classical v Keynesian)

Depends on success of interpretation of data and forecasting

Impact on other macro-economic factors

Quantitative Easing

https://www.youtube.com/watch?v=J9wRq6C2fgo When interest rates alone are not enough. 1. Bank creates electronic money 2. Buy financial assets from financial institutions (government bonds)

3. Demand for bonds , price of bonds and yield 4. Financial institutions then have more money to lend out or buy corporate bonds or shares

5. Corporate bond price and yield - 6. Cheaper and easier for commercial banks to raise finance and more willing to lend at lower commercial rates

7. Stimulate borrowing, C, I therefore AD

Advantages of monetary policy Disadvantages of monetary policy

1. Interest rates have a direct and powerful effect on household spending, which suggests that UK consumers are highly interest rate elastic.

2. The Bank of England’s Monetary Policy Committee is independent from government and can make decisions free from political interference.

3. Interest rates can be adjusted eight times a year, which contrasts with discretionary fiscal policy which cannot be adjusted at such regular intervals.

4. While the full effects of interest changes may not be experienced for up to a year, there is often an immediate effect on confidence. The time-lag on output is estimated to be around one year, and on the price level, around two years.

1. There are still time lags to see the full effects, and there are some negative effects.

2. Raising interest rates can negatively affect on investment spending and the housing market, and the exchange rate and hence the balance of payments.

3. There is also the problem of the dual economy - are high rates set for the booming service sector, or low rates for the depressed manufacturing and export sector?

4. The money supply is difficult to control in practice, so controlling interest rates is preferable.

5. Interest rates may fall to very low levels during a deep recession, and while the demand for credit may rise, the supply may become trapped in the system, known as the liquidity trap.