1. AS Economics
Monetary Policy

2. The Bank

3. The Bank of England

4. What is monetary policy?

5. 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 is D
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.

6. 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.

7. 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 independence for the Bank of England

8. 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
BoE – March 2009 – IR at 0.5%

9. 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
Since 1997, the BoE has had operational independence in the setting of interest rates. The Bank aims to meet the Government's inflation target - currently 2.0 per cent for the consumer price index- by setting short-term interest rates. Interest rate decisions are taken by the Monetary Policy Committee (MPC) at their monthly meetings.
New ‘in’ term …
Quantitative easing!

10. mortgages savers Credit Card holders In debt spenders Pensioners
How does a
fall in
Interest rates
effect different
sectors of the
economy?
savers
Credit
Card
holders
In debt
spenders
Pensioners

11. 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
The Bank of England is charged with the task of 'maintaining the integrity and value of the currency'. The Bank pursues this objective through the use of monetary policy. Above all, this involves maintaining price stability, as defined by the inflation target set by the Government, as a precondition for achieving a wider goal of sustainable economic growth and high employment.

12. Monetary Policy Committee
Main objective for the Bank of England:
Meet the inflation target: Inflation of 2.0%
Monetary policy is designed to be pre-emptive (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.

13. 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!
A 2 day meeting! Wed – review of latest ec data.

14. Members….
9 members
Governor
2 Deputies
2 Bank executive directors
4 govt appointed members

15. Setting Rates – The Economic Assessment
Demand-side factors
Real GDP growth
Estimate of the output gap
Consumer spending
Net Exports (Trade)
Government spending
House Prices
Unemployment
Consumer borrowing
Business & Consumer Confidence
Supply-side factors
Wages and earnings
Labour Shortages
Import prices
Commodity prices (e.g. oil)
International Factors
Sterling Exchange Rate
Global Inflation Trends
EXAM SKILLS > they will be expected to prioritise….select some factors…
It is important to note that monetary policy in Britain is designed to be pro-active and forward-looking. This means that the MPC is aware that changes in interest rates take time to work through the economic system. Making decisions on interest rates on the basis of today’s inflation data simply does not make sense. The Economists at the Bank must make regular forecasts of inflation and consider whether the current level of interest rates is appropriate in order to meet the inflation target. The reaction of consumers and businesses to interest rate movements is uncertain, as are the time lags arising from a change in interest rates. So the Bank of England undertakes a rigorous assessment of conditions in the economy, together with forecasts from its own economic model to find an appropriate rate of interest for the economy as a whole.
Vital theory!

16. Prioritise activity
Which 3 factors do you consider to be THE MOST important factors for keeping IR’s low in UK?

17. 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.

18. An Inflationary Gap What type of inflation is this?
LRAS
Price level
Above full-employment
equilibrium
Inflationary
Gap
SRAS
How could the BoE use IR’s to manage this?
How could the Govt use fiscal policies to manage this? AD
If aggregate demand means that real GDP exceeds trend output, there is a risk of demand pull inflation …. The MPC may decide to raise interest rates to choke off some of the excess demand
Real National Output

19. Base Interest Rates – The Long Run Picture
There is no unique rate of interest in the economy. For example we distinguish between savings rates and borrowing rates. However interest rates tend to move in the same direction. For example if the Bank of England cuts the base rate of interest then we expect to see lower mortgage rates and lower rates on savings accounts with Banks and Building Societies
Still at 0.5%

20. IR’s effecting mortgage holders
IR’s winners and losers

22. 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

23. Transmission Mechanism…. What would happen if IR’s rise?

24. Transmission Mechanism if IR’s rise

25. One side WINNERS Other side Losers…
Alternative – W or L on forehead ….!

26. 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.

27. 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
Domestic
Demand
I.e. C + I + G
Aggregate
Demand AD
Drives short-term
economic
growth
Asset prices
E.g. house prices
Domestic
Inflationary
Pressure
i.e. changes
in the output gap
(actual GDP relative
to potential GDP)
Official Interest
Rate
Set by the MPC
Net
External
Demand
i.e. X - M
Expectations and
Confidence
Businesses & consumers
Import
Prices
Consumer Price
Inflation
Exchange rate

28. 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
How does an interest rate rise affect household sector consumption and savings decisions? (i) It reduces the “effective” disposable incomes of mortgage payers hence reduces consumer spending (ii) It raises borrowing costs discouraging C and encouraging an increase in the saving ratio (iii) It reduces demand for houses. A slowdown in the housing market reduces consumer wealth and confidence resulting in lower consumer demand
WEALTH EFFECT CHANNEL
Expansionary Monetary Policy
Rise in Equity Prices
Rise in Land and House Prices
Rise in Value of Financial Wealth
Increase in Economic Activity

29. 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

30. Will there ever be 0% IR?
To what extent will 0% interest rates help an economy out of a recession?
Note:
2008 news article

31. 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
The reaction of consumers and businesses to interest rate movements is uncertain, as are the time lags arising from a change in interest rates. So the Bank of England undertakes a rigorous assessment of conditions in the economy, together with forecasts from its own economic model to find an appropriate rate of interest for the economy as a whole.
Evaluation issues

32. 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

33. On one side write Monetary
AS Economics
White board activity
On one side write Monetary
and on the other Fiscal
Monetary Policy

34. You decide – is it monetary or fiscal?
A cut in corporation tax
A restriction on bank lending
A reduction in the budget deficit
An increase in govt subsidies
An increase in interest rates
Now decide will each of these policies
REFLATE / EXPAND or
DEFLATE / CONTRACT
the economy?
Ask students to raise board above head for reflate or lower board to desk level for deflate….

35. 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?

36. 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?

37. HOMEWORK

38. Next lesson
Return of BoP past paper work
Review of Budget
Exam revision – another past paper review