GCSE Economics 3.4 Managing the Economy Monetary Policy

Images © thinkstockphotos.co.uk Learning Outcomes Demonstrate understanding of monetary policy, including the role of interest rates; Understand how interest rate policy works to achieve a target rate of inflation; Describe how a government uses monetary policy to try to achieve its key economic objectives; Explain the Bank of England’s role in implementing monetary policy. Images © thinkstockphotos.co.uk

Images © thinkstockphotos.co.uk Definition Monetary policy - Government policy on the cost and availability of credit in the economy mainly through control over the rate of interest. The Bank of England’s Monetary Policy Committee has independent control over the official interest rate in trying to achieve a target rate of inflation set by the Chancellor of the Exchequer Images © thinkstockphotos.co.uk

The Bank of England’s Monetary Policy Committee They inject money into the economy through quantitative easing August 2016: 1.25% As at Jan 2017 £435bn Images © thinkstockphotos.co.uk

Basics of Monetary Policy Monetary policy involves changes in: - The rate of interest - The money supply Images © thinkstockphotos.co.uk

Basics of Monetary Policy These changes are made with the intention of: influencing the level and growth of aggregate demand and output Meeting the Bank of England’s inflation target of 2% Images © thinkstockphotos.co.uk

The Control of the Money Supply The money supply is simply the total amount of money in an economy. The government will sometimes increase the money supply, through a process called quantitative easing, in order to stimulate spending in an economy. As of January 2017 the current level of quantitative easing stands at £435bn. Images © thinkstockphotos.co.uk

Images © thinkstockphotos.co.uk Video Clip Watch the video clip from the BBC for a brief description as to how quantitative easing works. http://www.bbc.co.uk/news/business-16974497 Images © thinkstockphotos.co.uk

Images © thinkstockphotos.co.uk Quantitative Easing Quantitative Easing is an injection of money into the banking system which should increase the money supply in an economy. Central Bank The central bank purchases bonds from the banking system This essentially creates money Financial Institutions Financial institutions such as banks get an injection of money This builds up their capital making them more likely to lend Borrowers Borrowers should find it easier to find a bank willing to lend Higher lending will boost spending in the economy and therefore AD. Images © thinkstockphotos.co.uk

Interest Rate Activity Consider the two scenarios below. Who will benefit / lose out and why? Images © thinkstockphotos.co.uk

Interest Rates and Economic Growth A rise in interest rates will increase the reward for saving, encouraging people to save. It will also increase the cost of borrowing meaning new borrowing becomes more expensive and repayments on existing borrowing increase. These impacts are likely to reduce Consumer Expenditure in the economy and therefore reduce AD and reduce economic growth. A fall in interest rates will decrease the reward for saving, encouraging people to spend instead. It will also decrease the cost of borrowing meaning new borrowing becomes less expensive and repayments on existing borrowing decrease. These impacts are likely to increase Consumer Expenditure in the economy and therefore increase AD and increase economic growth . Images © thinkstockphotos.co.uk

Images © thinkstockphotos.co.uk Inflation The government use monetary policy to achieve their target rate of inflation = 2% If inflation is above the target of 2% then it needs to be reduced. The Bank of England will want to reduce spending in the economy to reduce demand-pull inflation and will therefore increase the rate of interest. If inflation is below the target of 2% then it needs to increase. The Bank of England will want to encourage spending in the economy and will therefore reduce the rate of interest. Images © thinkstockphotos.co.uk

Images © thinkstockphotos.co.uk Interest Rates A rise in the interest rate causes an appreciation of the domestic currency This means imports become cheaper and exports become more expensive. This causes the current account position to deteriorate. A fall in the interest rate causes a depreciation of the domestic currency This means imports become more expensive and exports become cheaper This causes the current account position to improve. Images © thinkstockphotos.co.uk

Images © thinkstockphotos.co.uk Activity 1 Complete the table explaining the impact of a rise / fall in the interest rate on macroeconomic objective. What is the impact on: A rise in the interest rate A fall in the interest rate Economic Growth Unemployment Inflation Images © thinkstockphotos.co.uk

Images © thinkstockphotos.co.uk Activity 2 Complete the table explaining the impact of a rise / fall in the interest rate on macroeconomic objective. What is the impact on: A rise in the interest rate A fall in the interest rate Economic Growth Saving increases and borrowing decreases. Spending decreases so consumer expenditure decreases. This causes a contraction in growth in the economy. Saving decreases and borrowing becomes more attractive. Consumer expenditure increases. This causes an increase in the growth of an economy. Unemployment Due to a fall in demand in the economy, less workers are required to produce goods and services so unemployment increases. Due to the increase in demand from the increase in spending, more people are required to produce goods and services therefore unemployment decreases. Inflation Due to the decrease in spending and contraction of growth this puts downwards pressure on inflation, helping to reduce an inflation rate that may be too high. Due to the increase in spending and growth of the economy, demand-pull inflation is likely to occur if the economy is operating close to the full employment level of output. Images © thinkstockphotos.co.uk

Images © thinkstockphotos.co.uk Activity 3 Following the recession in 2008 when interest rates were 5%, the Bank of England gradually reduced interest rates. In March 2009, the Bank of England made a final cut in interest rates to a low of 0.5% This interest rate was maintained until August 2016 when rates were cut once again to 0.25% Questions: What would you expect to happen to the UK economy as a result of the changes in interest rate in 2008-2009? Why do you think the Bank of England didn’t raise interest rates again in the period 2009-2016? Images © thinkstockphotos.co.uk