3.2 Monetary Policy

Question 1

What is money?

Answer 1

Anything that people regularly use to buy goods and services, and for the repayment of debts

Question 2

What are the four functions of money?

Answer 2

• Medium of exchange
• Store of value
• Unit of account
• Standard for deferred payments

Question 3

What is monetary policy?

Answer 3

Monetary policy involves the manipulation of the bank rate, the supply of money, or the exchange rate, to influence economic performance

Question 4

What is the monetary transmission mechanism?

Answer 4

The process by which changes in monetary policy influence market rates of interest, asset prices, confidence/expectations and the exchange rate; all of these variables affect overall macroeconomic performance and the rate of inflation in particular

Question 5

What are the 4 types of unconventional monetary policy?

Answer 5

• Quantitative easing (asset purchases)
• Funding for Lending Scheme (FLS)
• Forward Guidance
• Negative bank rate

Question 6

What are the advantages of monetary policy?

Answer 6

• Change in monetary policy can instantly influence financial markets via commercial banks on their own interest rates
• Bank rate can be changed gradually to minimise fluctuations in economic activity -> less uncertainty
• Monetary policy is flexible - decisions made at regular intervals
• Monetary policy decisions are made independent of the government unlike fiscal -> less chance of influence by political objectives

Question 7

What are the disadvantages of monetary policy?

Answer 7

• May not be sufficient to overcome a major economic shock
• Changes in the bank rate may not be the most influential factor affecting AD (eg. confidence more influential)
• Subject to a limit on how low the bank rate can go (lower bank rate = greater chance of liquidity trap)
• Firms and households being able to access increasingly globalised financial markets may reduce the effectiveness of domestic policy
• Subject to time lags -> may cause economic fluctuations, however, time lags are usually shorter than some forms of fiscal policy
• QE can have negative distributional effects
• Monetary policy has economy-wide effects while fiscal policy can target specific sectors

Question 8

What are some evaluative points for monetary policy?

Answer 8

• The size of the change in bank rate and the initial interest rate
• Whether the reduction in the bank rate is passed on by commercial banks
• The level of spare capacity in the economy at the initial equilibrium
• The extent to which productive capacity may be affected by monetary policy changes
• The size of the multiplier
• Consumer and business confidence
• The extent to which other factors affect AD
• The extent to which there are conflicting policy objectives