The Bank

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The Bank

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2. The Bank

3. The Bank of England

4. What is monetary policy?

5. 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

6. The aim of monetary policy BoE – March 2009 – IR at 0.5%BoE – March 2009 – IR at 0.5%

7. The instruments of monetary policy Monetary policy involves the use of interest rates and other instruments of policy to control The growth of aggregate demand (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.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.

9. 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. 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.

10. 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.

11. Reading the macroeconomic tea-leaves

12. Members…. 9 members Governor 2 deputies 2 bank executive directors 4 govt appointed members

13. 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 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.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.

14. 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

15. An Inflationary Gap 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 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

16. 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 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

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

19. The effects of interest rate changes

20. LOW… interest rates: Who gains and who loses? 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.

21. How Monetary Policy affects AD

22. Channels of Monetary Policy 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 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

23. Interest rates and effective disposable income

24. 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.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.

25. 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

26. Quick review: Monetary and Fiscal Policy Monetary Policy The main instruments of monetary policy are (i) Interest rates (ii) Changes in the exchange rate (iii) Changes in the supply of credit Fiscal Policy The main instruments of fiscal policy are (i) Government spending (ii) Direct taxation (iii) Indirect taxation (iv) Government borrowing

27. White board activity On one side write Monetary and on the other Fiscal

28. 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

29. 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?

30. 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?

31. Will there ever be 0% IR? http://news.bbc.co.uk/1/hi/business/7791425.stm To what extent will 0% interest rates help an economy out of a recession?

33. Homework… Using the budget summary Identify demand side policies (D) Identify supply side policies (S) Which issues are fiscal policies? (F) Which issues are monetary policies? (M)

34. Next lesson homework Another exam paper

35. Data response – Interest rates….

36. 40 marks Explain what is meant by inflation. (2 marks) Define investment. (2 marks) Use aggregate demand and supply analysis to explain the likely effects of a fall in company investment on UK prices and real output.(5 marks) Assess the significance of two items of information, other than those mentioned in the extract, which the Monetary Policy Committee may have considered before reaching its decision to cut interest rates. (6 marks) Explain the likely effect on inflation of the fall in the value of the pound (Extract 1, line 3) (6 marks) Outline the likely effects on income distribution of the fall in interest rates. (4 marks) Evaluate the effectiveness of monetary policy as a means of achieving price stability in the UK economy. (15 marks)

37. Essay Q – 30 marks… Definition and outline … (6 marks); Explanation (12 marks) of which, up to 6 marks each for two transmissions mechanisms explained in depth with examples, or up to 4 marks for three transmissions mechanisms explained clearly). Evaluation (12 marks)

39. Homework Green definition sheet AND How to measure inflation…. Your own explanation!

40. Recap on how deflation is measured….!

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