MONETARY POLICY

MPCs Considerations
Oil Prices:
* Major F.O.P; if oil prices fall; COPs
fall- hence price level falls. May need
to reduce interest to reach 2%.
Unemployment:
* High unemployment = low
consumption = fall in AD = low price
level.
House prices:
* If prices are high = larger
mortgages = less disposable Y = low
consumption, falling AD and falling
price level.
Wages:
* Wages increase = firms reduce
supply due to higher COPs = higher
prices.
How it works
The Transmission Mechanism:
Consumption:
* High interest rates deter
borrowing; increase saving
(greater opportunity cost).
* Higher interest on mortgages
increases payments, therefore
reducing real disposable income =
less consumption.
Investment:
* Investment is less attractive to
firms due to increase cost of
borrowing.
Exchange rates:
* High interest = inflow of money
(hot money) = higher AD = high
value = expensive X; cheap M = low
COPs = disinflation.

Evaluation
Advantages:
* The Bank of Englands MPC is
independent from the
government; could be suggested
there will be no govt. failure.
*Changes often affect
consumer/firms/foreign
CONFIDENCE immediately.
* Easier to control interest than
money supply.
Disadvantages:
* Time lags to see full effects (up
to 2 years)
* Interest rates tend to worsen
income distribution.
* Can negatively effect
investment and housing market.
* Interest rate increases COP;
worsens inflation rather than
curing it.
Diagram
Explanation
* Higher interest rate
leads to fall in AD due to
a fall in consumption
and investment (higher
costs of borrowing; less
incentive to spend)-
hence real output and
employment fall from Y
to Y1 and price level
falls from 3.5% to 2.0%
improving the inflation
(as it has achieved the
target). Process works
vice-versa.
Definition
* Changing the rate of interest in
order to achieve 2% inflation.
*Altering exchange rates to also
influence inflation.
* Tight M.P = higher interest.
*Loose M.P = lower interest.

Quantitative Easing
Bond: buying Govt. debt in return
for the money plus interest.
Step 1: BoE create electronic
money- credits own account.
Step 2: BoE buys bonds from
banks/financial institutions. Banks
use this money to loan out
(multiplier effect)
Step 3: Banks lower interest due to
surplus cash- stimulating economy.
Step 4: BoE sells bonds and
destroys cash; money supply has
not increased hence no inflation.