Monetary Policy AS Economics. What is monetary policy? Controlling the macro-economy through changes in monetary variables such as – Money supply – Interest.

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Presentation transcript:

Monetary Policy AS Economics

What is monetary policy? Controlling the macro-economy through changes in monetary variables such as – Money supply – Interest rates This has become more common since the 1980s Since 1997 has been managed independently by the BOE

Interest rates Is the main instrument of monetary policy BOE sets the base rate which does affect other rates such as banks’ lending and borrowing rates

How IR affects AD IR rise Mortgage payments rise Disposable incomes fall Consumption falls as income is diverted to mortgages Inflationary pressure falls (DP) Also borrowing for investment (I) falls reducing pressure on prices for resources It can take 2 years for a change to have an effect and confidence can be influenced too Remember the OPPOSITE happens too!

Monetary Policy The Interest Rate Transmission mechanism – The process by which a change in interest rates feeds through to AD

The Interest Rate Transmission Mechanism 1 Interest Rates Borrowing Individuals Credit Loans Consumption Firms New Loans Investment Existing Loans CostsEmploymentMargins Consumption

The Interest Rate Transmission Mechanism 2 Interest Rates Mortgages Existing New Consumption Investment Disposable Income Property Equity Demand for New Housing SavingsConsumption

The Interest Rate Transmission Mechanism 3 Interest Rates Exchange Rates Appreciation Mp Xp Dm Dx Depreciation Mp Xp Dm Dx Balance of Payments

Real Interest Rates Real interest rates need discounted for inflation Nominal rate = 5% Inflation = 3% Real rate = 2% What is the real rate when… Nominal is 3% and inflation is 2.1% Nominal is 4% and inflation is 4% Nominal is 6% and inflation is 10%

Impact of changes Housing – increase cost of mortgages and reduce demand for new housing (and associated businesses – analysis) Disposable income of mortgage payers – can lead to negative equity if house prices fall Consumer demand for credit Consumer and business confidence Business investment – remember links to multiplier and negative multiplier! Exchange rate – a higher IR than competitors can strengthen the £ e.g. £1 = €1.10 to £1 to €1.30

Monetary policy and AD/AS If AD is approaching FE then using monetary policy to reduce AD can create spare capacity by shifting AD to the left and reduces inflationary pressure, and make goods and services more competitive to export markets What is the cost of this to UK workers? Remember the opposite can happen too in order to increase AD!

Monetary Policy Supply of Money: – Narrow Money – notes and coins in circulation (M0) – Broad Money – Notes and coins plus money held in bank and building society accounts (M4) A rise in either (ceteris paribus) might signal a rise in aggregate demand (AD)