Monetary policy

Question 1

–Define Monetary and Monetary Policy

Answer 1

• Relating to money or currency.
• Action that a country’s central bank or government can take to influence how much money is in the economy and how much it costs to borrow.

Question 2

What does Monetary policy involve?

Answer 2

the central bank taking action to influence the manipulation of interest rates, the supply of money and credit, and the exchange rate.

Question 3

The determinants of the demand for money

Why do people hold money instead of alternative assets e.g. bonds, stocks, durable goods)

Answer 3

J.M. Keynes said for these three reasons:
1. Transactions demand
2. Precautionary demand
3. Speculative demand

Question 4

Transaction demand

Answer 4

Househoulds and firms need to hold a certain amount of money for its useful as a medium of exchange

Question 5

Precautionary demand

Answer 5

• A certain amount of money holdings are desired by households and firms in order to meet unplanned emergencies
• Unplanned expenditures: unexpected illness, unemployment etc
• Will rise with incomes

Question 6

Speculative demand

Answer 6

• Arises from the perception that money is optimally part of a portfolio of assets being held as investments.
• People will hold money with anticipation that value of non money assets will fall in the future

Question 7

In terms of the demand for money, what is the opportunity cost money has

Answer 7

The income which could have been accrued had it been held in the form of other assets

Question 8

What does the the opportunity cost of money mean for interest rates

Answer 8

Inverse relatonship between the quantity of money demanded and the cost of holding it; the interest rate. The higher the opportunity cost of liquidity, the less you will buy.

Question 9

The alternative to holding money

Answer 9

• If the interest rates rises a smaller quantity of money will be demanded but a larger quantiyty of other financial assets will be desired; Bonds.
• If the interest rates falls a larger quantity of money will be demanded because the lower interest rates does not make it worthwile to forego the conveniance of money

Question 10

When individuals are holding more money then they need there is excess

What does decreased excess supply of money lead to

Answer 10

• An Increased quantity of bonds demanded
• Causing the price of existing bonds to rise
• Meaning the interest yield on those bonds will fall
• The value of interest payments on a bond is fixed, but the actual yield (rate of return) is not
• Therefore; Interest rates have an inverse relationship to bond prices

Question 11

The theory of the supply of money

Answer 11

• At any given time there is a specific fixed stock of money in the economy
• (assuming that the supply of money is solely determined by the banking system and BoE)
• The equilibrum between the demand schedule and supply schedule is the equilibrum interest rate
• This is the interest rate that equates the quantity of money demanded with the quantity of money supplied

Question 12

Open- Market Operations; increasing money supply

Answer 12

• If BoE wants money supply to increase & interest rate to fall it will buy bonds & bills; it will pay for them with cheques drawn on itself
• The sellers will deposit these cheques, causing their banks’ balances with the BoE to increase
• This will give the banks larger holdings of liquid reserve assets, forming the basis for increased lending
• Banks will do this as giving loans is generally profitable, causing money supply to increase

Question 13

Open market operations expansionary and contractionary and interest rates

Answer 13

• expansionary: banks increase their lending, rightward movementr in the money supply, equilbirum rate of interest falls, investment increases, AD increases + investment multiplier, equilbiorum level of real national incomes rises
• Contractionary: supply of money shift to the left, equilbirum rate of interest rises, decrease in total planned expenditures, decrease in real national income

Question 14

The Transmission mechanism (leading on from open market operations)

Answer 14

Definition: When changes in the money supply bring about changes in the equilibrium level of real national income
1. A change in monetary policy
2. A multiple change in the money supply
3. A change in the interest rate
4. A change in investment
5. A multiple change in income

Question 15

The MPC’s view of
the transmission mechanism (condensed)

Answer 15

1. Official interest rate decisions affect market interest rates. + Policy announcements affect expectations & confidence about the future course of the economy
2. Changes in the official interest rate affect the demand for goods and services produced in the UK.
3. The level of demand relative to domestic supply capacity is a key influence on domestic inflationary pressure.
4. Exchange rate movements have a direct effect, though often delayed, on the domestic prices of imported G&S and an indirect effect on the prices of those G&S that compete with imports

Question 16

Monetary policy and the nature of unemployment

Answer 16

If people are made unemployed by demand deficiency then monetary expansion and increased spending will create the jobs they can fill. But if they are unemployed for structural reasons + labour immobilties, then increased spending will not help unless at least some of it is geared to measures whcih will be effective in overcoming immobilties.

Question 17

The quantity theory of money

Answer 17

• Changes in the money supply result in changes in the price level
• The link between money and prices is shown through the equation of exchange (developed by Irving Fisher at Yale Uni in early 1900s)
• Has been proclaimed the oldest surviving theory in economics.

Question 18

Velocity of circulation

Answer 18

• how many times money is changing hands
• The average number of times per year that the nation’s stock of money is spent on purchasing the economy’s annual flow of output (GNP)

- M = total money supply
- V = GNP / M
- Turns into MV = GNP
- GNP = P x Q
- MV = PQ (the equation of exchange)

Sometimes Q is T for transactions

Question 19

Accounting identity

Answer 19

An equality that must be true regardless of the value of its variables, or a statement that by definition (or construction) must be true.
- Fisher Equation: MV = P
- Balance of payments: Current Account Surplus + Capital Account Surplus = Increase in Official Reserve Account
- GDP = C + I + G + (X − M)
- Investment = Fixed investment + Inventory investment
- Bank assets = Bank liabilities + Owners’ equity
- The most basic identity in accounting is that the balance sheet must balance, that is, that assets must equal the sum of liabilities (debts) and equity

Question 20

Quantity theory of money in proving inflation

Answer 20

• The general price level of goods and services is directly proportional to the amount of money in circulation
• P = M x V/Q
• If we assume that both V and Q are fairly constant, then, as M increases or decerases so to does P, and at the same rate.
• V is assumed to be fairly constant because it based on the long run money holding habits of firms and consumers
• Q is assumed to be fairly constant because the economy tends towards full employment

Question 21

Quantity theory of money in proving inflation example in 1970s

Answer 21

The inflation of the 1970s is explained as being a by-product of the money supply expansions caused by debt financing by governments striving to maintain full employment

Question 22

What were the problems in implementing Monetarism

Answer 22

Central Banks found it harder than anticipated to control the money supply, especially after they had deregulated the banking system to make it freer and more competitive. This meant that they had to have recourse to very high nominal rates of interest. Furthermore, the recessions which resulted from tight monetary policies turned out to be long and severe.