AS Macro Revision: Monetary Policy and Exchange Rates


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AS Macro Revision: Monetary Policy and Exchange Rates

  1. 1. AS Macro Revision Monetary Policy and Exchange Rates Spring 2014
  2. 2. We add new resources / links / articles every day to our Economics blogs Follow this link for the AS Macro Blog on Tutor2u
  3. 3. Different Interest Rates in the Economy An interest rate is the reward for saving and the cost of borrowing expressed as a percentage of the money saved or borrowed • There are many different interest rates in an economy • Interest rates on savings in bank and other accounts • Borrowing interest rates • Mortgage interest rates (housing loans) • Credit card interest rates and pay-day loans • Interest rates on government and corporate bonds • Interest rates serve more than one function: • To compensate for risk (i.e. Risk of default) • To compensate for inflation which reduces real debt levels • Central banks such as the Bank of England normally set the price of money using policy interest rates to regulate the economy
  4. 4. Interest Rates on Loans A rise in interest rates increases the cost of paying back loans taken out by consumers and businesses In recent years the average mortgage interest rate on home loans has fallen, but the interest rate on overdrafts and credit cards has actually increased towards 20%
  5. 5. Negative and Real Interest Rates An interest rate that is below zero. For real interest rates, this can occur when the inflation rate is higher than nominal interest rates • The real rate of interest is important to businesses and consumers when making spending and saving decisions • The real rate of return on savings is the money rate of interest minus the rate of inflation. So if a saver is receiving a money rate of interest of 6% on his savings, but price inflation is running at 3% per year, the real rate of return on these savings is only + 3%. • Real interest rates become negative when the nominal rate of interest is less than inflation, for example if inflation is 5% and nominal interest rates are 4%, the real cost of borrowing money is negative at -1%.
  6. 6. Factors Considered When Setting Policy Interest Rates The BoE sets policy interest rates consistent with the need to meet an inflation target set of consumer price inflation of 2% 1. 2. 3. 4. 5. GDP growth and spare capacity / estimates of output gap Bank lending, consumer credit figures, retail sales Equity markets (share prices) and house prices Consumer confidence and business confidence Growth of wages, average earnings, labour productivity and unit labour costs, surveys on labour shortages 6. Unemployment and employment data, unfilled vacancies 7. Trends in global foreign exchange markets (i.e. Is sterling appreciating or depreciation against other currencies) 8. International data – e.g. Growth rates in economies of trading partners such as USA and Euro Area
  7. 7. Policy Interest Rates in the UK Economy The policy interest rate is set each month at the meeting of the Bank of England’s Monetary Policy Committee When the Bank’s policy interest rate changes, most of the other loan and savings interest rates in the financial markets will also change too
  8. 8. Main Challenges Facing the Bank of England Controlling price inflation and keeping inflation expectations low Supporting a sustainable / durable economic recovery Re-balancing the economy towards exports and investment Financial stability – building a more secure banking system
  9. 9. Transmission Mechanism of Monetary Policy 1 / Change in market interest rates Normally a change in policy interest rates feeds through to borrowing/saving rates 2/ Impact on demand Is there an expansion of production and employment? Effect on spending, saving, investment and exports 3/ Effect on output, jobs & investment Rate changes then affect two of the key macro objectives 4/ Real GDP and Price Inflation It can take between 12-24 months for the full effects on real GDP and the inflation rate after a change in interest rates
  10. 10. When Interest Rates Fall A reduction in interest rates or an increase in the supply of money and credit is an expansionary or reflationary monetary policy Cost of servicing loans / debt is reduced – boosting spending power Consumer confidence should increase leading to more spending Effective disposable income rises – lower mortgage costs Business investment should be boosted e.g. Prospect of rising demand Housing market effects – more demand and higher property prices Exchange rate and exports – cheaper currency will increase exports An expansionary monetary policy is designed to boost confidence and demand during a downturn / recession
  11. 11. Limits to the Effects of A Cut in Nominal Interest Rates Commercial banks reluctant / unable to lend Some interest rates have actually risen High stock of personal debt Low Business & Consumer Confidence Falling real incomes for savers
  12. 12. Interest Rates and the Distribution of Income When interest rates fall, there is a re-distribution of income away from lenders and savers towards borrowers with loans / debt Incomes of savers • If the interest on savings is less than inflation, savers will see a reduction in their real incomes Incomes of home-owners with mortgages • If interest rates fall, the income of home-owners who have variable-rate mortgages will increase Interest rates on unsecured debt • Lower interest rates on loans such as credit cards and bank loans will fall
  13. 13. Get help on the AS macroeconomics course using twitter #econ2 @tutor2u_econ
  14. 14. Quantitative Easing (QE) • When policy interest rates are at zero or close to zero, there is a limit to what conventional use of monetary policy can do • In March 2009 the BoE started quantitative easing for first time. • The main aim of QE is to support aggregate demand and avoid a recession becoming a deflationary depression • Bank of England uses QE to increase the supply of money in the banking system and encourage banks to lend at cheaper interest rates – especially lending to small/medium sized businesses • The Bank does not print new £10, £20 and £50 notes, it uses money created by the central bank to buy government bonds • There are doubts about the effectiveness of quantitative easing – bank lending has struggled to recover since the end of the recession. At the end of 2013, the QE programme totalled £375bn
  15. 15. Some of the Recent Changes to UK Monetary Policy There have been a number of important changes in the handling of monetary policy by the Bank of England in recent years • Quantitative Easing (QE) 2009 – buying bonds to increase deposits and lending by the banking industry • Project Merlin (2011) - agreement between banks & Government to increase lending to small/medium-sized businesses • Funding for Lending Scheme (2012) – joint policy between Treasury and the BoE which provides cheaper funding to banks that increase their loans to households and businesses • Forward Guidance (2013-14) - under forward guidance, the Bank’s policy rate will remain at 0.5% at least until unemployment falls to 7% or until there are clear signs that the amount of spare capacity in the economy has reached normal levels
  16. 16. The Financial Policy Committee of the BoE In addition to the Monetary Policy Committee, there is a new body at the Bank of England – the Financial Policy Committee (FPC) • The FPC is charged with safeguarding financial stability • The Monetary Policy Committee works through setting policy interest rates and the scale of quantitative easing (QE) • The Financial Policy Committee can operate directly on the supply and price of credit in the banking system • The FPC has the power to alter loan-to-value ratios (e.g. Ratio of a mortgage loan to house prices) • It can also change the cash reserve requirements or capital buffers for commercial lenders – e.g. They might insist that banks keep a higher proportion of new deposits in cash rather than lend them out to businesses and households
  17. 17. Forward Guidance when Setting Interest Rates • Forward Guidance was introduced by Mark Carney in August 2013 • It has been signalled that the Bank of England will leave their policy interest rates unchanged as long as the unemployment rate is above 7.0% and inflation is under control • The main aim is to build confidence by signalling that interest rates would stay at low levels for some time • In February 2014, Mark Carney signalled that forward guidance would evolve – LFS unemployment is not the sole data measure to be used
  18. 18. Interest Rates, Inflation and Unemployment The Bank of England’s main focus is on controlling inflation – but they must also consider the wider economic picture For most of the time that interest rates have been at 0.5%, inflation has been above target. Will interest rates rise in 2014? Both inflation and unemployment are falling
  19. 19. We add new resources / links / articles every day to our Economics blogs Follow this link for the AS Macro Blog on Tutor2u
  20. 20. Credit Policy (Monetary Policy) Credit is created by the banking system – the UK economy along with many other countries has a high stock of unpaid debt • Conventional monetary policy focuses on the effects of • Changes in interest rates for borrowers and savers • Changes in the supply of money in the economy • Changes in the value of a country’s exchange rate • Credit policy is becoming important in many countries – affecting economic growth / recovery • Policies that impact on credit supply • Reforms to the banking system
  21. 21. The Credit Squeeze – Banks and Business Lending • Commercial banks have lowered their willingness to take risks when lending • Rise in non-performing loans (bad debts) which have contributed to heavy losses - Total loan write-offs were over £11bn in 2012 • Higher deposits and tougher checks to get a mortgage • New (tougher) global rules (known as Basel III) on the amount of capital and liquidity that banks must hold • Many businesses in the UK have become “credit constrained”
  22. 22. Evaluation Points on Interest Rates & Monetary Policy • Time lags should be considered when analyzing effects of interest rate changes • Monetary policy not an exact science – consumers and businesses don’t always behave in a textbook way! • Many factors affect costs and prices which can change inflation risks in a country • Monetary policy does not work in isolation! Consider how fiscal policy is affecting the economy • Objectives of monetary policy can change – the USA Federal Reserve’s mandate is “maximum employment, stable prices, and moderate long-term interest rates”
  23. 23. Get help on the AS macroeconomics course using twitter #econ2 @tutor2u_econ
  24. 24. The Exchange Rate The exchange rate is the rate at which one currency can be exchanged for another i.e. £1 buys $1.60 £ has been appreciating against the US dollar in the second half of 2013 A depreciation of the exchange rate means that £1 buys fewer US dollars ($) The UK operates with a floating exchange rate – the external value of the currency is determined purely by market forces of supply and demand for a particular currency.
  25. 25. How a Weak Currency can affect Macro Objectives Changes in the exchange rate affect demand for exports and imports; real GDP growth, inflation, business profits and jobs Inflation • A fall in a currency leads to a rise in import prices • Causes a rise in cost-push inflationary pressure Export demand and trade balance • Weaker currency makes exports cheaper overseas • Rising export sales & a stronger trade balance Real GDP and jobs • Rise in exports and fall in imports will increase AD • Higher export profits is boost to the labour market
  26. 26. Economic Effects of a Currency Depreciation When the pound depreciates against the US dollar It makes UK import prices RISE It makes UK export prices FALL Changes in import and export prices will affect demand Import sales will CONTRACT Export sales will EXPAND This will have an effect on a number of key economic indicators Domestic production  Trade deficit  Domestic jobs 
  27. 27. Evaluating the Effects of a Currency Depreciation In theory a depreciation of the exchange rate provides a boost to aggregate demand and economic growth ....but this depends on.. 1. The length of time lags as consumers and businesses respond 2. The scale of any change in the exchange rate i.e. a 5%, 10%, 20% 3. Whether the change in the currency is short-term or long-term – i.e. is a change in the exchange rate temporary or likely to persist 4. How businesses and consumers respond to exchange rate changes – the value of price elasticity of demand is important i.e. will there be a large change in demand for exports & imports? 5. The size of any second-round multiplier and accelerator effects 6. When the currency movement takes place – i.e. Which stage of an economic cycle (recession, recovery etc)
  28. 28. The Effects of a Currency Appreciation A currency appreciation makes exports more expensive & is likely to lead to an inward shift of AD GPL A currency appreciation makes imports cheaper & likely to cause an outward shift of AS GPL AS AS1 GPL1 GPL1 GPL2 GPL2 AD1 GPL3 AD2 Y2 Y1 Real GDP AS2 AD1 AD2 Y2 Y3 Y1 Real GDP
  29. 29. The Exchange Rate and Unemployment • An exchange rate appreciation causes a slower growth of real GDP because of a fall in net exports (a reduced injection) and a rise in the demand for imports (an increased leakage in the circular flow). • A reduction in demand and output may cause job losses as businesses seek to control their costs. • Thus a higher exchange rate can have a negative multiplier effect on the economy. • Some industries are more exposed to currency fluctuations – e.g. sectors where a high % of output is exported and where demand is price sensitive (price elastic)
  30. 30. Get help on the AS macroeconomics course using twitter #econ2 @tutor2u_econ