MONETARY POLICY, THE MONEY SUPPLY AND INTEREST RATES. A2 Economics

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1 MONETARY POLICY, THE MONEY SUPPLY AND INTEREST RATES A2 Economics

2 The Specification

3 Introductory Research/Reading Task Go To: Create a Fact Sheet of 10 key facts related to UK Monetary Policy Explore/read all of these sections:

4 Money What is money? What functions does it perform in our economy?

5 The Functions of Money A medium of exchange Accepted in exchange for goods/services and avoids having to resort to barter A store of value or wealth Enables us to hold back purchasing power for until we wish to use it Enables relative values to be expressed Using identical units to express value (i.e. pounds) we can compare the relative value of items Confidence in future value allows payment to be deferred In a developed economy goods are frequently purchased on credit, with the amount repaid in the future. This is possible because when are confident about the future value of money.

6 Financial Assets Liquidity: the degree to which financial assets can be easily converted into money Cash shares Current accounts Deposit accounts Treasury bills Property The liquidity spectrum

7 The Money Supply There are 2 general types of money supply: Narrow Money: notes, coins and balances available for normal financial transactions Referred to as M0 by the Bank of England Broad Money: money held in banks and building societies which is not immediately accessible. This money is held in accounts for which notice is required to make withdrawals Referred to as M4 by the Bank of England

8 Significance of 5% increase in money supply - stability Page 172 Banks monitor supply of broad money as an indicator of overheating or cooling in the economy Broad money is considered to be relatively liquid more so than property Linked to the quantity theory of money, an annual increase in the money supply of >5% would give an early warning sign of inflation An increase of <5% may signal a downturn in economic growth or falling prices In times of economic uncertainty such as 07/08 firms and households prefer to keep more of their wealth in cash or more liquid bank accounts This explains why the broad money supply has increased in 15.3 Quantity Theory of Money: MV PY

9 Financial or Physical Assets? Individuals and firms hold a variety of financial assets Financial assets: cash, bank accounts and shares Physical assets: property, consumer durables, art and fine wines

10 Extended Study Due Mon 12 March Complete ECON 4 Key terms dictionary of all key terms covered so far using text book There may be a gap where you haven t covered the key terms yet from where Mr Walter is doing Fiscal and Supply Side and I am doing Monetary Policy so review the dictionary for ones you have covered right to the end

11 Recap Qns 1. Explain 1 of the functions of money 2. Explain what is meant by the liquidity of financial assets 3. Explain the difference between the broad and narrow money supply 4. Explain the quantity theory of money

12 LO: To analyse the determinants of the interest rate

13 Interest Rate Demand for Money The demand for holding money is determined by 2 key factors: Income The higher the level of income the greater the demand for money in order to facilitate spending An increase in income can be seen in the shift from DM1 to DM2 The rate of interest Money can be used to buy financial assets like bonds which generate interest. The higher the rate of interest the higher the opportunity cost of holding money. Therefore high interest rate, low demand for money. Low interest rate, high demand for money. Quantity of money DM2 DM1

14 Interest Rate The Rate of Interest The equilibrium rate of interest is at re where the demand for money equals the supply of money MS The rate of interest is effectively the price of holding money re = equilibrium interest rate Qe = equilibrium quantity re Qe Quantity of money DM1

15 Interest Rate MS If the demand for money increases following an increase in incomes more money will be demanded at every interest rate The equilibrium rate of interest will increase from r1 to r2 r2 r1 DM2 DM1 Qe Quantity of money

16 Interest Rate If the government or central bank increase the money supply the MS curve will shift outwards MS 1 MS 2 This will lead to a fall in the interest rate A reduction in the money supply would have the opposite effect and increase the interest rate r1 r2 Q 1 Q 2 DM1 Quantity of money

17 Interest Rate Independent Consolidation Draw a diagram to show the impact on the interest rate when: MS 1. Incomes increase 2. The money supply increases 3. Incomes decrease 4. The money supply decreases r 1 Q 1 Quantity of money

18 Interest Rate Markets We are working on the assumption that there is only one market for interest rates In reality there are many interest rate markets those for bonds, credit cards and mortgages Although it is fair to say that all interest rates do tend to move in the same direction, following the Bank of England Base Rate Although having said that give the financial difficulty that banks have experienced since the 2008 credit crunch, even though the base rate may be 0.5%, banks have been reluctant to pass these cost savings on to consumers

19 Base Rate: The interest rate a bank sets to determine its lending and borrowing rates. It will tend to offer interest rates below the base rate to savers, whilst charging rates above the base rate for borrowers.

20 Real and Nominal Interest Rates Nominal Interest Rate: Interest rate not adjusted for inflation Real Interest Rate: The nominal rate of interest minus the rate of inflation 0.05% - 3.6% = Money will be losing value

21 For each of these HSBC Savings products calculate the nominal and real interest rate:

22 Reading At this point re-read chapter on Monetary Policy from AS text book

23 Monetary Policy Objectives Monetary Policy Objective: a target or goal that the Bank of England aims to meet Since the late 1970s the main objective of monetary policy has been controlling inflation Changing approaches to achieving this: Mid 1970s-1985 Focus on the Money Supply Known as the Monetarist Era Policy makers believed that inflation arises directly from an increase in the quantity of money MV PY This approach was abandoned in 1985 as it became clear that the money supply was very difficult to control and the relationship outlined by the quantity theory of money (MV PY) seemed to break down in the 1980s Focus on the Exchange Rate Focus on the money supply was replaced with focus on the exchange rate The aim was creating a high value of the pound This reduced inflationary pressure as the relative price of imported food and consumer goods fell The relative price of imported oil and raw materials also falls which helps to reduce cost-push inflation 1992-present Focus on the Interest Rate

24 Current UK Monetary Policy Since 1992 the principle instrument of Monetary Policy has been the Interest Rate This is used to influence the demand for money rather than the supply Since 1992 UK Monetary Policy has involved meeting a published inflation rate target set by the government The MPC estimate what the inflation rate will be in 18 months time if interest rates remain unchanged Based on this in comparison to the target inflation rate the MPC will change interest rates accordingly If inflation is more than 1% higher or lower than the target of 2% the Governor of the B of E (Mervyn King) is required to write an open letter to the Chancellor (George Osbourne) explaining why the situation has occurred and what the bank intends to do to bring it back to within target range Whilst the primary objective of Monetary Policy is price stability the B of E is also obliged to support the governments other macroeconomic objectives

25 Bank of England Open Letters

26 Process Overview Government set Inflation Rate Target (2%) MPC use their instruments to influence the demand and supply of money and therefore ultimately the Interest Rate The Interest Rate aims to facilitate the achievement of the Inflation Rate Target (2%) How this filters through is known as the Transmission Mechanism of Monetary Policy and more on this later

27 Interest Rate Monetary Policy Instruments Policy Instruments: A tool or method of control used to try to achieve an objective Controlling the Supply of Money MS 1 MS 2 Reserve asset ratios: Forcing banks to hold a certain proportion of their total assets in reserve Quantitive Monetary base controls: Direct controls on bank lending which impose maximum limits on the amount that banks can lend Qualitative Monetary base controls: Direct control on bank lending which instruct banks only to lend to certain customers e.g. business customers Open market operations (OMOs): The Bank of England can issue government bonds When purchased they pass money back to the central bank This reduces the money supply as the money lodged at the Bank of England is not counted as part of the money supply r1 r2 Q 1 Q 2 Quantity of money DM1

28 Interest Rate Monetary Policy Instruments Policy Instruments: A tool or method of control used to try to achieve an objective Controlling the demand for Money By increasing/decreasing the interest rate For example, an increase in the base rate by the B of E will mean that high street banks will increase the interest rates they charge to their customers. As a result households and firms will reduce their demand for credit and seek to repay existing loans. DM1 Quantity of money

29 The MPC Hold monthly meetings Required to consider a large volume of economic information ahead of each meeting The data is summarised in the minutes published 2 weeks after the meeting see booklet

30 What data do the MPC study to inform their decisions? Includes data on: Financial markets The international economy Money and credit Demand and output The labour market Costs and prices What does it tell us? Share prices an indicator of investor/consumer confidence and a determinant of household wealth Recent developments in the US, Eurozone and Asia. Trends in exchange rates. Movements in narrow and broad money will be analysed. Bank lending and consumer credit figures. Consumption and investment will be considered. Rate of growth of Real GDP and estimates of the size of the output gap. Un/employment figures. Looking for signs of wage inflation. Manufacturer surveys of costs and prices are used to analyse whether firms are passing increasing costs on to the high street

31 Problems of Accurately Forecasting Inflation In practice it is very difficult to forecast inflation with great accuracy Aside from general difficulties the possibility of external shocks always exists such as natural disasters, terrorist attack or the outbreak of war In order to deal with the unpredictability, The B of E uses a Fan Chart in its Inflation Report, published quarterly see booklet

32 The Transmission Mechanism of Monetary Policy The Transmission Mechanism of Monetary Policy: the process by which a change in interest rates affects aggregate demand and inflation

33 The Transmission Mechanism of Monetary Policy Stage 1 Base rate changes Banks, building societies and other financial institutions reach by changing their own saving and loan rates Asset prices such as shares and property are also affected Expectations change people may feel more or less confident The exchange rate may change as demand and supply of sterling adapt to the new interest rate

34 The Transmission Mechanism of Monetary Policy Stage 2 There is an effect on domestic demand as AD is affected and consumers and firms look to cut back spending There is an effect on external demand or demand from other countries as the level of exports and imports adjusts in response to the changes in the exchange rate These feed together to give total demand

35 The Transmission Mechanism of Monetary Policy Stage 3 Total demand feeds through to domestic inflationary pressure which is dependent on the relative balance between AD and AS AD increases will not be inflationary is there is adequate spare capacity Changes in the exchange rate feed through into import prices These two factors come together to determine total inflation

36 Monetary Policy Stance Refers to whether Monetary Policy is intended to stimulate or depress AD, or perhaps allow AD to grow in line with the countries long-term underlying growth rate (2.5% for UK the rate at which the UK can grow at whilst maintaining stability i.e. no output gaps) Expansionary Monetary Policy: aimed at reflating AD Contractionary Monetary Policy: aimed at depressing AD Neutral Monetary Policy: neither aimed at increasing or decreasing AD, i.e. no positive or negative output gaps

37

38 In Real Terms Economic Analysts have argued that monetary policy is: Monetary Policy Stance Expansionary Interest Rate 4% and below Neutral 5-5.5% Contractionary Above 5.5%

39 The Spec Simplified How Bank of England influence the money supply How Bank of England influence the rate of interest Objectives of Monetary Policy Identify and explain instruments currently employed by Bank of England to achieve the inflation rate target set by Gov How demand and supply of funds on different markets affect interest rates Understanding of factors considered by MPC when setting interest rates

40 The Spec Simplified How Bank of England influence the money supply - instruments How Bank of England influence the rate of interest instruments, controlling D and S of money Objectives of Monetary Policy have changed over time from money supply to exchange rate to interest rate Identify and explain instruments currently employed by Bank of England to achieve the inflation rate target set by Gov - instruments How demand and supply of funds on different markets affect interest rates d and s graphs Understanding of factors considered by MPC when setting interest rates data considered

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