Edexcel Economics notes 2.6.2 Part 1 – monetary policy

Contents

What is monetary policy?

Monetary policy: changes to interest rates, money supply and exchange rates. This includes quantitative easing.

In the UK, the Bank of England, specifically the Monetary Policy Committee (MPC) of 9 members, sets monetary policy for the UK economy.

This includes setting Bank Rate, the interest rate at which the Bank of England lends to other banks such as high street banks.

The Bank of England’s target rate of CPI inflation is 2%.

Subject to achieving the inflation target, the Bank of England has a secondary objective to support the UK’s Government’s economic policy. This usually involves achieving economic growth and full employment.

What are the effects of higher interest rates?

The interest rate is the cost of borrowing and the reward for saving.

Suppose the Bank of England raises its Bank Rate.

Then high street banks typically pass on the rate rises to their customers, so that interest rates rise throughout the economy.

What are the effects of higher interest rates?

• A fall in consumption
  • Higher interest rates lead to increased reward for saving and higher cost of borrowing.
  • So households save more and consume less. Households also borrow less.
  • This leads to a fall in consumption, so aggregate demand (AD) shifts left.
• A fall in investment
  • Higher interest rates increase the cost of borrowing. So firms borrow less to invest.
  • So investment falls, so AD shifts left.
  • Note this means that monetary policy also has supply-side effects:
    • Higher interest rates reduce investment. So the quality and quantity of capital falls. So productive capacity falls, so LRAS shifts left.
    • Higher interest rates also increase cost of borrowing, increasing business costs. This shifts the SRAS left.
• Lower house prices and negative wealth effects
  • The cost of borrowing rises. This includes borrowing, using a mortgage, to buy a house.to buy a house.
  • This reduces demand for housing, which reduces house prices.
  • For those who own homes, their total wealth falls.
  • As wealth has fallen, people feel less confident and so reduce consumption. This is a negative wealth effect.
• Fall in net exports
  • Higher interest rates increase demand for the domestic currency. Appreciation of the currency.
  • Imports cheaper and exports dearer. So export demand falls and import demand rises. This may reduce net exports, further reducing aggregate demand.
• Mixed effects on macroeconomic objectives
  • As a result of AD falling, the rate of economic growth falls.
  • Demand for labour is derived from demand for goods and services. So a fall in AD reduces demand for labour, leading to higher unemployment.
  • AD falling does lead to a lower rate of inflation. This may also increase demand for exports, increasing the value of exports and reducing the size of the current account deficit.
  • Suppose we account for the possible supply-side effects of monetary policy. Then this may change the effects of higher interest rates on inflation and the current account.
• Other possible effects include lower asset prices for other assets (shares, bonds), multiplier effects, or higher interest payments on government debt.

The effectiveness of higher interest rates depends on:

• Whether high street banks pass on increases in Bank rate to depositors
  • When the Bank of England raises its Bank rate, high street banks may decide not to pass on the interest rate rise to savers.
  • This is to help the high street bank keep its costs down, in this case the cost of paying interest.
  • As a result, interest rates may not rise for savers. So the reward for saving may not rise. So the incentive to save does not rise, so consumption does not fall.
  • High street banks in the UK were accused of not passing on interest rate rises to consumers quickly enough. Click here (external link) to read more.
• The level of spare capacity
  • However this depends on the level of spare capacity.
  • Suppose spare capacity is high, meaning the economy is operating inside its productive potential, not making full use of the factors of production.
  • Then the Keynesian LRAS is (perfectly) elastic with respect to the price level
  • Either:
    • So firms can flexibly change aggregate supply in response to price level changes.
    • OR relate to a real world situation when there was high spare capacity. For instance, the 25% unemployment rate in the US in the 1930s Great Depression.
  • Then a shift left in AD does not lead to a fall in the price level.
  • So inflation falls to a lesser degree.
• The level of consumer (or business) confidence
  • Suppose consumer confidence is high.
  • Then consumers may believe the economy is likely to continue to grow in the future. So consumers think they are more likely to see increases in income in the future.
  • So consumption remains high and consumers may not respond much to an increase in the interest rate. So AD may not fall as much.
  • Relate this to a situation with high consumer confidence.
    • For instance, UK consumer confidence reached a three year high in August 2024 (although the consumer confidence score was still negative).
• Other possible points could include:
  • The size of the multiplier effect.
  • Whether firms invest by borrowing or from retained profits.
  • The total level of consumer debt or the total level of saving.

What are the effects of quantitative easing?

Quantitative easing (QE) is when the central bank uses digital money to buy government bonds from financial institutions (commercial banks, pension funds).

What is a government bond?

• A government bond is a type of loan from the bondholder to the government.
• Owning the bond gives the bondholder the right to receive repayments on the amount of money borrowed, as well as interest payments.
• The bond itself can be bought and sold between different bondholders in the “secondary market” for bonds. This is the market in which quantitative easing intervenes.

Quantitative easing (QE) has the following effects: 

• How QE works – the four step process:
  • First, the central bank, such as the Bank of England, creates digital money.
  • Then the central bank uses this digital money to buy government bonds from financial institutions, like banks and pension funds.
  • As a result, this gives these financial institutions more to spend. So they may give out more loans (and at lower interest rates) to businesses or households.
  • By making it easier and cheaper to borrow, investment and consumption increase.
• Alternatively, financial institutions may put their extra funds into buying corporate bonds.
  • A corporate bond is similar like a government bond, except a company has created this bond to borrow too.
  • This increases demand for corporate bonds, raising their price but lowering their interest rate.
    • The price of a bond and the interest rate are inversely related.
    • Suppose the price of a bond is £100. Buying the bond gives a fixed £10 coupon or interest payment per year. That’s a 10% rate of return (interest rate) per year on buying the bond.
    • Suppose now the price of the same bond doubles to £200. With the fixed £10 coupon payment per year, the rate of return falls to 5% a year (10 divided by 200).
    • In other words, as the price of a bond rises, its interest rate falls.
  • This makes it cheaper for firms to borrow by issuing corporate bonds, so firms borrow more to invest, so investment rises.
• Overall, investment and consumption increase, so aggregate demand shifts right.
  • This leads to higher inflation and higher real GDP.
  • As a result of higher investment, there can also be a positive multiplier effect. This would shift AD further to the right.
• Currency falls in value relative to other currencies:
  • By reducing interest rates, there may be hot money outflows to other countries where interest rates are higher, where investors can earn a higher return.
  • This reduces demand for the domestic currency, so the currency falls in value relative to other currencies.
  • This makes exports cheaper and imports dearer. So export demand rises and import demand falls. So the value of net exports rises.
• Falling government borrowing costs:
  • When the central bank buys government bonds from commercial banks, it increases bond demand, decreasing bond interest rates.
  • This makes it cheaper for the government to borrow.
• Supply-side effects:
  • As QE can lead to higher investment, this can increase the total amount or productivity of capital and labour.
  • This boosts productive capacity, shifting the LRAS right.
• Higher asset prices:
  • As financial firms have more funds to invest, additional investment may see increased demand for assets such as stocks (a small part of a company) or housing.
  • This boosts demand for these assets, leading to higher asset prices.
  • Wealth effect – those who do own assets, such as houses, are likely better off from QE. This may generate a positive wealth effect for this group. Higher asset values mean households are richer, so consumption goes up.
  • However, higher asset prices makes it more difficult to afford a home for those trying to get on the housing ladder.
• The possibility of asset price bubbles
  • As asset prices rise, there is a risk that asset prices become inflated above their fundamental value.
  • This situation is called an asset price bubble.
  • This can occur particularly for assets with more volatile prices. This includes commodities such as metals and oil or even cryptocurrency.
  • Investors are taking on greater risk if they trade more in volatile assets. This creates a risk that investors may lose money if the asset price bubble pops.
• Inequality effects
  • QE makes banks and financial institutions richer. Those with assets benefit from rising asset prices.
  • If house prices rise as a result of QE, those who do not own housing are worse off – it becomes more difficult for them to afford a house.
  • Therefore inequality may rise as a result of QE.
  • However the Bank of England argues that because QE increased employment and incomes, QE benefitted low and middle incomes groups too.
  • So without QE, the Bank of England argues that inequality would be higher. Those on low and middle incomes would face a greater risk of losing their jobs and experiencing extended spells of unemployment.

The success of QE depends on:

• The level of spare capacity or the position of the economy on the Keynesian LRAS curve.
  • If the economy has high spare capacity, then shifts right in AD have a lesser effect on inflation.
• How financial institutions allocate their extra funds.
  • Which assets this income goes towards, for instance stocks in companies or more volatile investments such as commodities.
  • Also high street banks may decide to hold on to extra funds rather than invest. This occurs particularly when banks are worried about there being a high risk of firm failure and bankruptcy.
• The degree of wealth inequality.
  • Greater wealth inequality means the benefits from QE are more likely to accrue to those with assets, such as bonds, stocks or housing, further increasing inequality.
• The size of any multiplier effect.
• Whether or how long it takes for QE to be reversed. If QE is maintained, then the inequality effects are more likely to be permanent.

For a long report on QE in the UK, see the link here.

Monetary policy case studies

1) Great Depression 1929 into 1930s – US and UK

• The Great Depression in the US:
  • The Great Depression saw a rise in unemployment from below 4% in 1929 to 25% in 1933 in the US. Real GDP fell by 26.6% from the 1929 peak to the 1931 trough.
  • Monetary policy in the US is seen as a contributor to the Great Depression.
    • The US was part of the gold standard until 1933.
    • The gold standard is when the money supply and hence value of a country’s currency is linked to the amount of gold held in reserve.
    • So, even if the central bank wanted to increase the money supply significantly to engage in expansionary monetary policy, the gold standard limits the ability of the central bank to do this.
    • Economists, such as Bernanke, Friedman and Schwartz, have argued that the monetary policy stance of the Federal Reserve contributed to the Great Depression.
• The UK’s experience of the Great Depression:
  • Compared to the US, the UK saw much less of a fall in output during the Great Depression years. Real GDP fell by 5.4% from the 1929 peak to the 1931 trough.
  • However, the UK left the gold standard in 1931, earlier than the US. This may have helped to mitigate some of the effects discussed by Bernanke, Friedman and Schwartz that occurred in the US.

2) 2007-8 global financial crisis – US and UK

• Monetary policy response included a cut in interest rates (about 5 percentage points cut in both UK and US). In the UK Bank Rate fell to 0.5%.
• Interest rates were reaching close to their “effective lower bound”.
  • If interest rates fall too far below zero, savers may prefer to keep their money at home in cash, rather than deposit money in a bank.
  • So central banks, if they cut interest rates further, cannot affect households’ incentives to spend as their cash would not be earning or losing interest. This is called a “liquidity trap”.
  • This gave central banks little scope for cutting interest rates further. So central banks tried other tools, such as quantitative easing.
• Advanced economies such as the UK and the US experimented with quantitative easing in response to the 2008 global financial crisis. In the UK, the Bank of England bought bonds worth £200 billion in response to the financial crisis and ended up expanding this to £375 billion QE in total.
• In the US under quantitative easing, the Federal Reserve central bank bought $4.5 trillion in bonds.
• While there is evidence that quantitative easing from this period has raised economic growth rates and reduced the rate of unemployment, it has also contributed to higher prices of shares and property.

3) Early 2020s in the UK

• Quantitative easing:
  • At its peak in 2020, the Bank of England has £895 billion of quantitative easing on its books. This was mainly government bonds but also a smaller amount of corporate bonds.
  • The Bank of England has engaged in quantitative tightening following economic recovery from the Covid pandemic.
    • One advantage of QE is that it is reversible. The reverse of QE is called “quantitative tightening” or QT.
    • In QT, the central bank sells bonds to private banks or other agents.
    • This reduces the amount of bank funding available for loans, so there is less borrowing, lower investment and lower AD. 
    • As a result of QT, the Bank of England’s asset purchases (mostly government bonds) under quantitative easing are down to £691 billion as of July 2024.
  • While high inflation in 2022-23 in the UK was partly driven by energy price shocks, expansionary monetary policy has also been partly blamed for high inflation in this period.
• Interest rates:
  • The Bank of England’s interest rate, Bank rate, has risen from 0.1% in 2021 to 5.25% in August 2023.
  • Bank rate remained at 5.25% until it was cut to 5% in August 2024.
  • Banks in the UK faced accusations of not passing on interest rate rises to savers quickly enough. 
  • Higher interest rates in the UK in 2022-24 contributed to disinflation. Specifically, the UK rate of CPI inflation has fallen from 11.1% in October 2022 to 2.2% in July 2024.
  • However, higher interest rates have also contributed to a falling economic growth rate. The UK economy entered recession at the end of 2023, with the economic growth rate being -0.3% in the fourth quarter of 2023.

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