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Monetary Policy

The government can influence the economy through the use of monetary policy. To do this,
they control interest rates, money supply and exchange rates.
How do interest rates affect AD?
1. Housing market
A fall in IR will decrease housing payments/mortgages. This therefore increases
demand for houses, which also increases price of houses. It also increases the
wealth effect (the price of their asset rises, which makes people feel wealthier). This
increases consumption, and thus aggregate demand. However, the exception is the
liquidity trap.
Liquidity trap
Keynes believed that higher government borrowing may not lead to higher IR, if the
economy is in a deep depression. When there is a liquidity trap, borrowing can
increase without IR increasing. This occurs as lenders are prepared to increase the
supply of money without a rise in IR. Monetary policy alone cannot be used to get the
economy out of the depression as IR is very low and consumers are not willing to
borrow due to poor expectations they have about the future. A decrease in IR does
not cause an increase in consumption or investment.
2. Wealth effect
If IR increased, the demand for houses would fall, which would subsequently
decrease the wealth effect. If there is a low interest rate, there will be increased
demand for bonds.
3. Investment
An increase in interest rates will lead to a fall in investment as the cost of borrowing
increases. There may be an opportunity cost.
4. Saving
An increase in interest rates will increase savings, thus creating a withdrawal.
5. Exchange rate
A decrease in the exchange rate will increase demand for domestic economy
(SPICED). Thus exports increase while imports fall.
6. Consumer durables
An increase in interest rates will decrease the demand for consumer durables. This
may impact employment, especially with regards to the accelerator.
What is the accelerator (theory)?
The accelerator theory states that whereas consumption is determined by national income,
investment is determined by changes in the national income. It will affect a firms investment
decisions as firms see an increase in consumption, they may invest, in the short term, in
new machines and capital equipment. In the short-term, this would lead to a monetary
increase in the physical capital supporting the increase in consumption.
Thus if the demand for durables fall, the reverse of the above occurs.
How will changes in the IR affect LRAS?

If IR is too high, the government may not


implement supply-side policies e.g.
infrastructure, decreasing the productive
capacity of the economy.

If IR increases, investment falls, which


decreases AD. If investment falls, LRAS
also falls.

Money
Money consists of coins and bank notes which are issued by the Bank of England, along
with deposits in high street banks and building societies. We are willing to accept these
tokens as a method of payment as we are confident that they will be accepted by others
when we decide to spend them.
The four functions of money

Medium of exchange: something that buyers give to sellers in exchange for goods
and services.

Store of value: When we work, we are paid a wage, and the portion of the wage that
is not spent is saved. By saving money, we are able to spend some now and some
later money serves as a store of value, allowing us to trade current consumption for
future consumption.

Standard of deferred payment: Money serves as the standard of deferred payment.


The lending and borrowing act are expressed in money. Due to the qualities of
stability in value, general acceptability and durability, money is regarded best for
transactions. Money encourages lending and borrowing.

Purchasing power of money falls when there is a rapid rise in the price of goods and
services the value of money is eroded, and people lose confidence. Thus, money
ceases to work as a standard of deferred payment after it loses confidence.

Unit of account: In the unit of account, money serves as the common base of
comparison that people use to present prices and record debts. E.g. if a normal TV
cost 100 and a HD TV cost 200, we know what this means and so are able to
compare prices.

Demand for money


Individuals and firms tend to hold a variety of financial assets, which can be divided into
financial assets and physical assets. Financial assets include cash, bank accounts and
shares, whilst physical assets include property, consumer durables and art.

The demand for money is determined by:


Income
o An increase in income will lead to an increase in demand for money. We need
money to spend the income; however, it depends on our marginal propensity
to consume.
Interest rates
o If the rate of interest increases, there is higher opportunity cost of holding the
money. Thus, the demand for money should fall.
The demand for money slopes downwards because a rise in the rate of interest increases
the incentive to hold interest bearing financial assets such as bonds. A rise in income will
shift the demand for money to the right (DM1 to DM2) at any given rate of interest, because
the requirement to hold money for spending transactions increases.

!
Rate of interest
The rate of interest is effectively the price of holding money. Below, we see the demand and
supply of money.
The demand for money is downward sloping because the rate of interest increases the
attractiveness of holding interest bearing bonds, and vice versa. It is usual to draw the
money supply as a vertical line as we assume that the central bank, such as the Bank of
England, can control the supply of money in the economy independently of its price. The
equilibrium rate of interest is at R1, where the demand for money equals its supply.
The demand for money increases, for example, following an increase in income, more
money will be demanded at any given interest rate and the interest rate will increase from
IR1 to IR2.

!
A fall in the demand for money will lead to a fall in the rate of interest. If the government
increases the money supply, the MS curve will shift to the right from MS1 to MS2. This will
lead to a fall in the IR from IR1 to IR2. A reduction in the money supply will lead to an
increase in the interest rate.

!
Above, we have assumed that there is only one market for money, when in reality, there are
many, offering different rates of interest (i.e. government bonds, credit cards, mortgages,
etc). However, IR do tend to move with the base rate which is set by the Bank of England. If
the Bank of England cuts the base rate, we expect to see the rates offered by other financial
institutions also fall. With the credit crunch in 2008, we saw IR not falling with the base rate
as readily as before due to the LIBOR rate remaining high. This shows the risk associated
with lending at the time.
Current UK monetary policy
Since 1992, UK monetary policy has involved meeting a published inflation target. Since
1997, the Labour government set up the Monetary Policy Committee to ensure this target
was met. At present, the target inflation rate is 2% and the MPC is charged with ensuring the
government does not under or overshoot this target. Thus, the Bank of England should seek
to stimulate AD to hit the rate. (Consider that inflation is difficult to forecast).
If banks deviate from this 2% by greater than or less than 1%, the MPC has to write a letter
to the Chancellor.

There has been an on-going discussion amongst economists that the Labour and Tory
government have relied on IR to manipulate AD and that fiscal policy should be used in the
future rather than monetary.
The transmission mechanism of monetary policy
The link between a change in the Bank of England official interest rate and changes in
inflation is known as the transmission mechanism. Monetary policy influences AD and
inflation in a number of ways.

The first stage is that a change in the official interest rate set by the MPC will affect
other interest rates. Banks, building societies and other financial institutions have to
react to any official rate change by changing their own savings and loan rates. The
change will also affect the prices of many assets; shares, houses, gilt-edged security
prices and so on. The exchange rate may change as demand and supply of sterling
adapt to the new level of interest rates. Finally there may also be an effect on the
expectations of both firms and individuals. They may become more or perhaps less
confident about the future path of the economy.

The second stage is that all these changes in markets will affect the spending
patterns of consumers and firms. In other words there will be an effect on aggregate
demand. Higher interest rates are likely to reduce the level of aggregate demand, as
consumers are affected by the increase in rates and may look to cut back spending.
There will also be international effects as the level of imports and exports change in
response to possible changes in the exchange rate.

The third stage is the impact of the aggregate demand change on GDP and inflation.
This will tend to depend on the relative levels of aggregate demand and supply. If
there is enough capacity in the economy then an increase in AD may not be
inflationary. However, if the economy is already at bursting point producing as much
as it can, then any further AD increase may be inflationary.

The banks IR decisions affect interest rates set by mortgage lenders, commercial banks,
and financial institutions. These same decisions and announcements influence the
confidence and expectations or firms and households as well as asset prices and the
exchange rate.

AD is therefore affected the domestic component of demand will be stimulated by lower


market IR as well as spending and investment by individuals and firms is boosted.
Conversely, higher market interest rates would tend to reduce domestic demand.
Furthermore, a fall in the official interest rate will lead to a rise in asset prices this leads to
the wealth effect, meaning that people become more confident about the future. This leads
to an increase in consumption. In addition, lower IR cause the exchange rate to fall; this
reduces the prices of domestic exports, whilst raising the price of imports. Demand for goods
and services thus increases.
Changes in AD can affect demand-pull inflation if there is little spare capacity. Cost-push
pressures may also arise from the effects of changes in AD on wage rates. Changes in the
relative prices of imported raw materials affect cost-push inflationary pressures. The Bank of
England estimates a time lag of up to 2 years between a change in the official rate of interest
and the subsequent changes in the rate of inflation.
The Bond Market
A bond is a promise to pay the bearer a specified amount of a specified day. Many firms and
governments sell bonds. It is not just an instrument for financial institutions insurance
firms, large companies, banks and governments also sell bonds.
Why are bonds sold? Say we owned a large firm, and we needed to extra capital to be
invested. If we were to sell the shares of the firm, we may be diluting the percentage of the
company that we own, and by borrowing money from a bank, we would be increasing the
risk the business has, as a loan needs to be repaid each month. A bond provides an
injection of cash now, as long as we pay the capital sum back in the future, plus a yield (or
an IR).

If we are an investor and a firm/government offers us a bond, but we think that they
are a very risky bet (i.e. Greece), we would expect a high interest/yield on top of the
bond.
If however, the firm/government is perceived to be a safe bet (i.e. Germany), there
would be a low interest rate/yield.
If there are a lot of investors that want to buy a specific bond from a firm/government,
the price of the bond will increase and the interest rate on the bond will fall.

Risk and relationship between the price and the yield of bonds
Assume a firm can buy a bond from the central bank. The central bank sells the bond for
100, which gives a 5% yield. The firm receives 5 on top of the bond.
Assume there is a risky firm selling bonds, and we want to make 5. As the bond is so risky,
the yield is 10%, otherwise no-one would purchase it. The price of the bond needs to be sold
for 50, giving us 5.
Assume that there is a safe firm offering bonds. As they are seen as a safe haven, a lot of
investors are willing to lend them money. Therefore, the yield they have to offer to investors
fall to 2.5%, and because there are a lot of investors, the price of the bond has risen to 250.
We receive 5.
If a firm can borrow cheaply, it is more likely to invest in machinery/equipment, or to buy
shares in other firms.
Quantitative Easing
Quantitative easing is a process whereby a Central Bank, such as the Bank of England,
purchases existing government bonds (gilts) in order to pump money directly into the

financial system. Quantitative easing (QE) is regarded as a last resort to stimulate spending
in an economy when interest rates fail to work.
Reducing short-term interest rates to encourage spending has long been the favoured policy
option of Central Banks when dealing with the threat of deflation and recession. However, if
aggregate demand fails to respond to ever-lower rates, another policy must eventually be
sought.
This is because nominal interest rates cannot fall below zero. Near-zero rates, together with
cash hoarding by individuals, corporations and commercial banks, resulted in liquidity being
trapped in the banking system, and contributed to the financial crisis in 2008.
How does QE work?
QE can work in a number of ways, but essentially it works by raising asset prices, starting
with government bonds, and then spreading out through the wider economy - this gives a
boost to bank assets and current bank lending and creates a positive wealth effect for asset
holders.
Although regarded widely as printing money, this is not the case. Printing money is more
associated with funding government debt, rather than QE, which is directly pumping money
into the economy to stimulate spending.
Quantitative easing by the Bank of England involves the following steps, and results in a
number of interconnected effects:

The Bank of England purchases existing corporate and government bonds held by
private businesses, including pension fund holders, insurance companies, private
firms and high street banks. This is done through an injection of electronic money.
These funds are credited to the investors accounts, which, initially improves their
liquidity.
The most immediate effect of the asset purchase is that prices of these existing
assets (gilts) rise, while yields - effectively, the interest on them - adjust downwards.
This encourages banks and other investors to look to rebalance their portfolios by
investing in other assets with a higher yield, such as corporate bonds and shares
(equities). As new investment occurs, the new liquidity is re-directed towards sellers
of bonds and shares. In addition, lower yields push down borrowing costs for
business, which can act as a stimulus to borrowing and spending.
The rise in the yields of other assets, such as shares, creates a wealth effect, with
holders of assets experiencing an increase in their wealth, raising confidence and
also stimulating spending. The positive effects of this may then spread out to the real
economy.

The hope is that:

Bank lending starts to flow again, leading to increased household and corporate
spending.
Confidence rises as lending and spending increase.
Aggregate demand increases and the economy moves out of recession.
The inflation target (2%) is achieved - rather than fall below target as might happen in
a recession or periods of low growth and poor expectations.

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