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Monetary Policy Review

A look at the Monetary Policy aspect of the AQA AS Economics course
by

O Carr

on 23 May 2012

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Transcript of Monetary Policy Review

Monetary Policy Interest rates What are interest rates? The Bank of England Base Rate is the amount banks pay to borrow from the Bank of England For example, an interest rate of 5% means that I pay £5 per £100 I borrow, usually over the course of a year Interest rates are the amount of money that you pay to borrow money, or the amount you earn when lending money Why are interest rates useful? By changing the interest rate, the Bank of England is able to affect the Aggregate Demand for an economy Reducing the interest rate increases Aggregate Demand, shifting the AD curve to the right Increasing the interest rate reduces Aggregate Demand, shifting the AD curve to the left How do interest rates affect AD? There are several ways in which a change in interest rate can affect Aggregate Demand The next few frames will look at these, and how these transition mechanisms work The Interest Rate Transmission Mechanism 1 Interest Rates Borrowing Individuals Loans Consumption Firms Loans Investment The Interest Rate Transmission Mechanism 2 Interest Rates Mortgages Consumption Disposable
Income Savings Consumption The Interest Rate Transmission Mechanism 3 Interest Rates Exchange Rates Appreciation Mp Xp Dm Dx Depreciation Mp Xp Dm Dx Balance of Payments Historical Interest Rates What this means If interest rates go up, borrowing becomes more expensive This means that firms and individuals will borrow less money This will mean there is less consumption and investment, both components of Aggregate Demand Therefore, AD will fall What this means If interest rates go up, mortgages become more expensive This means that individuals have less disposable income This will mean there is less consumption a component of Aggregate Demand Therefore, AD will fall What this means If interest rates go up, people get a greater return on any savings This means that individuals are more likely to save This will mean that people are consuming less - the opportunity cost of consuming has grown Therefore, AD will fall Key M = Imports
X = Exports
D = Demand
P = Price What this means If interest rates go up, the price of imports falls, and the price of exports rise This will mean the demand for imports increases and demand for exports falls this will lead to an increase in imports, and a fall in exports Therefore, AD will fall If interest rates go up, the demand for pounds rises as foreign countries put money in British banks UK Government Policy Monetary Policy Committee The MPC is independent of the UK government
This means that any decisions made by the MPC are not affected by the government directly
However, the government does set the MPC's target, which is that CPI inflation should be 2.0%
Inflation has recently been high, although the most recent figures show it dropping to 3.0% - within the acceptable tolerance for the MPC Quantitative Easing QE is a method of monetary policy used by the MPC to try to improve liquidity in the banking system
Liquidity is effectively the ease with which money can move between banks, firms, and individuals.
The Bank of England has injected £325 billion through QE to date
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