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Problem Focused Exercise: Monetary Policy- how is it decided?

The Scenario
The Monetary Policy Committee sets the interest rate each month in the UK. We explore how monetary policy affects the economy and the factors that are important in determining the Committees decision.

Task A

Read the short extract How Monetary Policy Works from the Bank of Englands website. From the article identify the following outcomes of a reduction in interest rates. (1) How does a reduction in interest rates affect a sequence of other things? Identify the direction of the changes in your answer. (2) (3) What economic objectives do interest rates affect? How do the effects need to be aggregated to consider the effect on the economy? What economic model (and associated diagram) is appropriate to use in such an analysis? feedback page 3

Task B
Read the extract from the Minutes of the Monetary Policy Committee meeting held on 3 and 4 August 2005. Given the evidence discussed by the Committee, consider whether this would lead the Monetary Policy Committee to increase, decrease or keep interest rates the same, and the size of any change. In doing this you should: Use an appropriate diagram. Explain why the economic concept of the multiplier is important in determining the Banks decision. Discuss any difficulties that the Committee might have had in coming to a decision. feedback page 5 or 7

Copyright: Embedding Threshold Concepts Project

26/08/07

This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.

Problem Focused Exercise: Monetary Policy- how is it decided?

How Monetary Policy Works

From interest rates to inflation

A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can affect consumers and firms cash-flow a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased. Lower interest rates can boost the prices of assets such as shares and houses. Higher house prices enable existing home owners to extend their mortgages in order to finance higher consumption. Higher share prices raise households wealth and can increase their willingness to spend. Changes in interest rates can also affect the exchange rate. An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents, tending to make sterling assets more attractive. That should raise the value of sterling, reduce the price of imports, and reduce demand for UK goods and services abroad. However, the impact of interest rates on the exchange rate is, unfortunately, seldom that predictable. Changes in spending feed through into output and, in turn, into employment. That can affect wage costs by changing the relative balance of demand and supply for workers. But it also influences wage bargainers expectations of inflation an important consideration for the eventual settlement. The impact on output and wages feeds through to producers costs and prices, and eventually consumer prices.

http://www.bankofengland.co.uk/monetarypolicy/how.htm

Extract from the minutes of the Monetary Policy Committee meeting held on 3 and 4 August 2005
In the first half of the year, output growth in the United Kingdom had been subdued. Household spending and business investment growth had slowed. Although there had been some signs of a pickup in consumer spending in Q2, downside risks remained in the near term given the loosening in the labour market and uncertainty about the underlying strength of consumer spending in the first half of the year. It seemed likely that the combined effect of high levels of household debt and the lagged impact of past interest rate increases had accounted for some of the unexpectedly sharp slowdown in consumer spending through 2004 and into the first quarter of 2005. It was possible that the uncertainty created by the ongoing adjustment in the housing market had also had some effect on spending.

http://www.bankofengland.co.uk/publications/minutes/mpc/pdf/2005/mpc0508.pdf

Copyright: Embedding Threshold Concepts Project

26/08/07

This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.

Problem Focused Exercise: Monetary Policy- how is it decided?

Feedback Task 1
(1) The article mentions a large number of ways interest rates affect other things in the economy. Examples are given in the relationships illustrated.

(a) Some initial variables affected


interest rates down savings down borrowing up share prices up house prices up

(b) A sequence of effects from one of these variables


Interest rates down house prices up consumer wealth up spending up

(2) The economic objectives are output, employment and prices (3) Aggregation of the effects
savings down/ borrowing up consumption and investment up Interest rates down asset prices up exchange rate down aggregate demand up exports up/imports down

Copyright: Embedding Threshold Concepts Project

26/08/07

This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.

Problem Focused Exercise: Monetary Policy- how is it decided?

Feedback Task 1 (cont) Intermediate


The question asks you to decide what model is appropriate to use The diagram(s) to be used in your answer depends to some extent on what you have covered in your course. There are several related diagrams that can be used. You could use: (i) The circular flow diagram the above is suggesting that certain injections/withdrawals may be changing. However this does not cover the effect on inflation. (ii) The Keynesian cross diagram. This illustrates the changes in aggregate expenditure (demand), but again does not cover the effect on inflation (iii) The IS-LM diagram can show the initial effect of the monetary policy change more clearly than other models, but again does not cover the effect on inflation (iv) The AD/AS diagram this does show the effect on prices (though it does not show the initial effect of the monetary policy as clearly as the IS/LM framework). If we are interested in the final effects on economic objectives this is arguably the best model to use. A fall in interest rates increases aggregate demand (AD) in figure 1 (we illustrate two cases as we shall use these in task B).
Figure 1: Aggregate Demand and Supply Case (a) LRAS P SRAS P5 P2 P1 P4 P3 AD2 AD1 Y1 Y2 Y Y3 Y4 AD2 SRAS Case (b) LRAS

AD1 Y

Copyright: Embedding Threshold Concepts Project

26/08/07

This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.

Problem Focused Exercise: Monetary Policy- how is it decided?

Feedback Task 2

Intermediate

How do we relate the policy decision to the diagrams? In deciding its policy the Monetary Policy Committee has essentially to decide if the economy is in a situation as reflected in diagram (a), at an output (and employment) below that given by the long-run aggregate supply curve (LRAS) or as in (b) where output is already equal to or above that given by the long run aggregate supply curve. In the first case a decrease in interest rates will increase aggregate demand, which will increase output with only a small effect on inflation. In the second a decrease in interest rates will lead to excess aggregate demand, which will increase output only in the short run and lead to a much larger effect on inflation (which is the main concern). Which of the diagrams is appropriate here? They will try and judge whether interest rates are too high by looking for signs of what is happening in various markets, such as: * Are consumption (sales) and investment falling or only growing very slowly (paragraph 1 in the first extract)? * Are house prices and share prices falling or only increasing very slowly (paragraph 2 in the first extract)? The second extract suggests that consumption (household spending) and investment had slowed and there are concerns expressed about the housing market. This would suggest diagram (a) is appropriate. What is the importance of the multiplier effect? Any change is magnified by the multiplier effect, so that relatively small declines now may become larger in a few months time. If, for instance, investment falls this will lead to a decrease in output. This in turn leads to a decrease in employment and incomes. This decrease in incomes leads to a further decrease in consumption, output, employment, incomes, etc., which is the multiplier effect. This may have led the Monetary Policy Committee to recommend reducing interest rates to prevent a further decline. Are there any difficulties in coming to this conclusion? All the signs are not in the same direction. The extract states there were some signs of a pickup in consumer expenditure in the last quarter. This could be a sign of the economy recovering on its own (as the multiplier effect kicks in). There is a problem of time lags as the monetary policy may not begin to work until the economy has already recovered and then this just adds to inflation. Because of the conflicting evidence and difficulties in judging the timing of policy, the change in interest rates is usually small. [Historical note: the evidence present to the Monetary Policy Committee at this date was considerably wider than this extract. However, the evidence in this extract was thought to be important and the committee voted to reduce the interest rate by 25 basis points ( of 1%) by 5 to 4 votes.]

Feedback Task 1 (cont) Basic


Copyright: Embedding Threshold Concepts Project 26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.

Problem Focused Exercise: Monetary Policy- how is it decided?

Decreased Savings & Imports

Circular Flow of Income

Rise in consumption

Increased Investment & Exports

Households

Firms

Rise in income

With an decrease in interest rates there is: An inc reases in injec tions. Investment and exports increase, in comes then increase as jobs are c reated and this inc reases consumption. T re is a he multiplier effec t with the inc rease in consumption. A reduc tion in withdrawals. Savings and imports fall, there is an inc rease in incomes and this increases c onsumption. T here is a multiplier ef fec t with the increase in consumption.

Copyright: Embedding Threshold Concepts Project

26/08/07

This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.

Problem Focused Exercise: Monetary Policy- how is it decided?

Feedback Task 2

Basic

As we saw above, interest rates affect aggregate demand (spending) in the economy. The committee will look for evidence for what is happening to aggregate demand is it growing too slowly or too fast given the inflation objective? For the evidence they will look at the effects on individual markets that we identified in section 1. What does the extract suggest is happening? * consumption (household spending) had slowed (and hence saving was rising) * investment had slowed * uncertainty due to adjustments in the housing market What will these do to aggregate demand (spending)? * it will grow more slowly or decline What is the importance of the multiplier effect? Any change is magnified by the multiplier effect, so that relatively small declines now may become larger in a few months time. If, for instance, investment falls this will lead to a decrease in output. This in turn leads to a decrease in employment and incomes. This decrease in incomes leads to a further decrease in consumption, output, employment, incomes, etc., which is the multiplier effect. Given what is expected to happen to aggregate demand, what should the MPC recommend? * a fall in interest rates Are there any difficulties in coming to this conclusion? However, all the signs are not in the same direction. The extract states there were some signs of a pickup in consumer expenditure in the last quarter. This could be a sign of the economy recovering on its own (as the multiplier effect kicks in). There is a problem of time lags as the monetary policy may not begin to work until the economy has already recovered and then this just adds to inflation. Because of the conflicting evidence and difficulties in judging the timing of policy, the change in interest rates is usually small. [Historical note: the evidence present to the Monetary Policy Committee at this date was considerably wider than this extract. However, the evidence in this extract was thought to be important and the committee voted to reduce the interest rate by 25 basis points ( of 1%) by 5 to 4 votes.]

Copyright: Embedding Threshold Concepts Project

26/08/07

This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.

Problem Focused Exercise: Monetary Policy- how is it decided?

Notes for lecturers


Objectives of the exercise and prerequisites
Learning Focus: Understanding the monetary transmission mechanism and the factors that will influence the decisions of the Monetary Policy Committee on interest rates. Threshold Concepts that are important are interactions between markets, economic modelling and cumulative causation.

Prior Knowledge Required


The students need to have been introduced to a model of the macroeconomy. In order to allow this exercise to be used with different groups of students (e.g. business students as well as those taking an economics award), or at different junctures in a module, the feedback is available at two levels for you to choose: (a) for students who have only covered the circular flow of income and a general introduction to the idea of the multiplier (labelled basic). (b) for students who have covered the AD/AS model (labelled intermediate).

Sequencing and timing


1. 2. Both tasks ask students to read an extract from the Bank of England and answer a series of questions. The tasks can be carried out on an individual basis but students may benefit from working in groups. Students can be asked to give a presentation of their findings to encourage participation (this can be certain selected groups rather than all in order to fit the time scheduling). It is possible to set task 1 without task 2. Task 1 is on the transmission mechanism and task 2 is on deciding the direction of monetary policy. Feedback for task 1 should be given before students attempt task 2. The exercise is likely to take 30- 40 minutes, without allowing time for presentations.

3. 4. 5.

Copyright: Embedding Threshold Concepts Project

26/08/07

This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.

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