Table of Contents
Monetary policy.......................................................................................................................................1
Conventional monetary policy = bank rate cuts – transmission mechanism..........................................................2
Evaluation..............................................................................................................................................................3
Bank rate increase.................................................................................................................................................3
Unconventional monetary policy...........................................................................................................................3
Quantitative easing................................................................................................................................................4
Forward guidance..................................................................................................................................................4
Funding for Lending Scheme..................................................................................................................................5
Financing government borrowing..........................................................................................................................5
Inflation targeting as an element of monetary policy............................................................................................5
Impacts of deflation...............................................................................................................................................6
Liquidity trap.........................................................................................................................................................7
Fiscal policy..............................................................................................................................................8
Fiscal rules.............................................................................................................................................................9
Taxation...............................................................................................................................................................10
Government budget................................................................................................................................10
Budget deficit/ increase in discretionary government spending..........................................................................11
Policies to reduce budget deficit..........................................................................................................................11
Determinants of the fiscal multiplier...................................................................................................................12
Government debt Evaluate the likely economic impact of high levels of government debt.................................12
Budget surplus.....................................................................................................................................................13
Fiscal austerity and increase in taxation during recession....................................................................................14
Automatic fiscal policy (stabilisation)......................................................................................................15
Discretionary fiscal policy.......................................................................................................................15
Expansionary fiscal policy....................................................................................................................................15
Contractionary fiscal policy..................................................................................................................................16
Supply side fiscal policy (interventionist policies)................................................................................................17
Supply side policies.................................................................................................................................17
Free market supply side policies..........................................................................................................................17
Financial markets...................................................................................................................................18
Monetary policy
, In 1997, the Bank of England was made solely responsible for monetary policy
Monetary policy aims to achieve government economic objectives through the use of policies like changes in interest
rates, the supply of money and credit and exchange rates. UK monetary policy is set by the Monetary Policy Committee of
the Bank of England and are independent in enacting these policies. Central bank objectives are to achieve monetary
stability by controlling inflation and financial stability by ensuring robust institutions.
The bank rate is the minimum interest charged when lending money to commercial banks to enable liquidity to meet
short term demands. The rate charged is usually above the LIBOR rate as they have to deposit securities like government
bonds as collateral.
Conventional monetary policy = bank rate cuts –
transmission mechanism
Domestic demand Net external demand
Market interest rates = direct impact on market interest Net export demand = hot money
rates as costs of borrowing for banks decreases Leads to capital flight and the selling of pound
Consumption increases as the cost of borrowing sterling due to low rates of return from the lower
decreases meaning more disposable income interest rates
Investment increases as businesses accelerate Causes the exchange rate to depreciate which
projects they would have delayed or cancelled due increases the competitiveness of exports on the
to lower costs of borrowing believing capital goods world market
can now be used profitably Prices of imports rise and become less domestically
competitive meaning the UK’s current account on
Asset prices the balance of payments improves, with the increase
Cost of household borrowing falls which cuts the in net export demand shifting AD to the right
cost of servicing a mortgage and credit card debt
May cause asset prices to increase and the wealth Inflation increases due to the rising total demand and
effect occurs which encourages greater consumption rising import prices
Investment increases due to a rise in confidence due
to rising asset prices Inflation
Causes cost push inflation due to imported inflation
Confidence from the increased price of raw materials and
Wealth effect and business confidence energy
Depreciation reduces UK export prices while raising
the price of imports causing demand pull inflation
However, freely floating exchange rate is likely to
limit this due to the negative feedback loop created
Disadvantages
1. Demand pull inflation and cost push inflation = 3. Negative impact on savers = savers hit badly by
currency depreciation causes import prices causing negative real interest rates and income from
cost push inflation but also exports to become pensions have fallen which are bad for long term
cheaper causing demand pull inflation. Likely to economic growth. Less injection into the circular
improve the current account on the BoP flow of income in savings and the positive
2. Keynesian liquidity trap = interest rates have a zero externalities that savings can bring in the financial
bound and Keynesians argue they will lose their sector
effectiveness when interest rates hit their lower 4. Time lags = the Bank of England estimates time lags
bound. Consumers and businesses would have of up to 2 years between initial changes and the
converted illiquid assets into liquid assets already, so changes in inflation. 1% change in bank rate affects
if central banks cut them further, it will have no output after 2 years by 0.2 – 0.4%
effect
, Evaluation
1. Size of the output gap = a deep recession = large 4. Bank’s willingness to lend/ pass on the full interest
output gap means it more effective and less likely to rate = LIBOR rigging could negatively impact the
cause inflation effectiveness of bank rate cuts on AD. In 2012 –
2. Size of the rate cut = determines the extent of its 2013, a financial scandal involving large banks like
effectiveness Lloyd admitted to mark-rigging LIBOR rates which
3. Consumer and business confidence = job and led to G20 recommending in 2014 that alternatives
promotion prospects mean they might have a like SOFR should be developed further. Gas between
greater MPC, with businesses being confident in the the LIBOR and bank rate may occur especially during
future economic state by investing in capital projects recessions as the risk of interbank lending increases.
Bank rate increase
P1: Control inflationary pressure Eval:
Low stable inflation helps promote Depends on the Marshall Lerner and reverse J-
macroeconomic stability and keep domestic curve condition
competitiveness and reduce uncertainty – Depends on how open a country is to free trade
monetary policy can stabilise the cycle and the confidence of foreign consumers and
Lower cost push inflation by causing currency businesses
appreciation which makes imports cheaper
Lower demand-pull inflation as it causes exports P2: Higher returns for savers and retirees
to become more expensive Rise in nominal interest rates improves returns
for savers many of whom have lose out in real
Eval: terms since the GFC
Freely floating exchange rate is likely to control Higher savings aids in debt repayments and can
this in a negative feedback loop act as a buffer to macro uncertainty and
Time lags between monetary change and increase injection into the flow of deposits into
inflation commercial banks which creates more liquidity
to support bank lending to finance business
P2: Currency appreciation investment which can increase LRAS
Higher interest rates may cause an inflow of hot
money thus causing a currency appreciation Eval:
This makes exports less competitive leading to a Risk of growth slowdown
slowdown in export sector output, investment Lower domestic consumption and investment
and employment No guarantee commercial banks will lend out
more if returns to savers improve
Rise in interest rates will likely lead to a
contraction in bank lending and make borrowing
more expensive especially for smaller
businesses and households who are dependent
on expensive unsecured credit
Unconventional monetary policy
Monetary policy.......................................................................................................................................1
Conventional monetary policy = bank rate cuts – transmission mechanism..........................................................2
Evaluation..............................................................................................................................................................3
Bank rate increase.................................................................................................................................................3
Unconventional monetary policy...........................................................................................................................3
Quantitative easing................................................................................................................................................4
Forward guidance..................................................................................................................................................4
Funding for Lending Scheme..................................................................................................................................5
Financing government borrowing..........................................................................................................................5
Inflation targeting as an element of monetary policy............................................................................................5
Impacts of deflation...............................................................................................................................................6
Liquidity trap.........................................................................................................................................................7
Fiscal policy..............................................................................................................................................8
Fiscal rules.............................................................................................................................................................9
Taxation...............................................................................................................................................................10
Government budget................................................................................................................................10
Budget deficit/ increase in discretionary government spending..........................................................................11
Policies to reduce budget deficit..........................................................................................................................11
Determinants of the fiscal multiplier...................................................................................................................12
Government debt Evaluate the likely economic impact of high levels of government debt.................................12
Budget surplus.....................................................................................................................................................13
Fiscal austerity and increase in taxation during recession....................................................................................14
Automatic fiscal policy (stabilisation)......................................................................................................15
Discretionary fiscal policy.......................................................................................................................15
Expansionary fiscal policy....................................................................................................................................15
Contractionary fiscal policy..................................................................................................................................16
Supply side fiscal policy (interventionist policies)................................................................................................17
Supply side policies.................................................................................................................................17
Free market supply side policies..........................................................................................................................17
Financial markets...................................................................................................................................18
Monetary policy
, In 1997, the Bank of England was made solely responsible for monetary policy
Monetary policy aims to achieve government economic objectives through the use of policies like changes in interest
rates, the supply of money and credit and exchange rates. UK monetary policy is set by the Monetary Policy Committee of
the Bank of England and are independent in enacting these policies. Central bank objectives are to achieve monetary
stability by controlling inflation and financial stability by ensuring robust institutions.
The bank rate is the minimum interest charged when lending money to commercial banks to enable liquidity to meet
short term demands. The rate charged is usually above the LIBOR rate as they have to deposit securities like government
bonds as collateral.
Conventional monetary policy = bank rate cuts –
transmission mechanism
Domestic demand Net external demand
Market interest rates = direct impact on market interest Net export demand = hot money
rates as costs of borrowing for banks decreases Leads to capital flight and the selling of pound
Consumption increases as the cost of borrowing sterling due to low rates of return from the lower
decreases meaning more disposable income interest rates
Investment increases as businesses accelerate Causes the exchange rate to depreciate which
projects they would have delayed or cancelled due increases the competitiveness of exports on the
to lower costs of borrowing believing capital goods world market
can now be used profitably Prices of imports rise and become less domestically
competitive meaning the UK’s current account on
Asset prices the balance of payments improves, with the increase
Cost of household borrowing falls which cuts the in net export demand shifting AD to the right
cost of servicing a mortgage and credit card debt
May cause asset prices to increase and the wealth Inflation increases due to the rising total demand and
effect occurs which encourages greater consumption rising import prices
Investment increases due to a rise in confidence due
to rising asset prices Inflation
Causes cost push inflation due to imported inflation
Confidence from the increased price of raw materials and
Wealth effect and business confidence energy
Depreciation reduces UK export prices while raising
the price of imports causing demand pull inflation
However, freely floating exchange rate is likely to
limit this due to the negative feedback loop created
Disadvantages
1. Demand pull inflation and cost push inflation = 3. Negative impact on savers = savers hit badly by
currency depreciation causes import prices causing negative real interest rates and income from
cost push inflation but also exports to become pensions have fallen which are bad for long term
cheaper causing demand pull inflation. Likely to economic growth. Less injection into the circular
improve the current account on the BoP flow of income in savings and the positive
2. Keynesian liquidity trap = interest rates have a zero externalities that savings can bring in the financial
bound and Keynesians argue they will lose their sector
effectiveness when interest rates hit their lower 4. Time lags = the Bank of England estimates time lags
bound. Consumers and businesses would have of up to 2 years between initial changes and the
converted illiquid assets into liquid assets already, so changes in inflation. 1% change in bank rate affects
if central banks cut them further, it will have no output after 2 years by 0.2 – 0.4%
effect
, Evaluation
1. Size of the output gap = a deep recession = large 4. Bank’s willingness to lend/ pass on the full interest
output gap means it more effective and less likely to rate = LIBOR rigging could negatively impact the
cause inflation effectiveness of bank rate cuts on AD. In 2012 –
2. Size of the rate cut = determines the extent of its 2013, a financial scandal involving large banks like
effectiveness Lloyd admitted to mark-rigging LIBOR rates which
3. Consumer and business confidence = job and led to G20 recommending in 2014 that alternatives
promotion prospects mean they might have a like SOFR should be developed further. Gas between
greater MPC, with businesses being confident in the the LIBOR and bank rate may occur especially during
future economic state by investing in capital projects recessions as the risk of interbank lending increases.
Bank rate increase
P1: Control inflationary pressure Eval:
Low stable inflation helps promote Depends on the Marshall Lerner and reverse J-
macroeconomic stability and keep domestic curve condition
competitiveness and reduce uncertainty – Depends on how open a country is to free trade
monetary policy can stabilise the cycle and the confidence of foreign consumers and
Lower cost push inflation by causing currency businesses
appreciation which makes imports cheaper
Lower demand-pull inflation as it causes exports P2: Higher returns for savers and retirees
to become more expensive Rise in nominal interest rates improves returns
for savers many of whom have lose out in real
Eval: terms since the GFC
Freely floating exchange rate is likely to control Higher savings aids in debt repayments and can
this in a negative feedback loop act as a buffer to macro uncertainty and
Time lags between monetary change and increase injection into the flow of deposits into
inflation commercial banks which creates more liquidity
to support bank lending to finance business
P2: Currency appreciation investment which can increase LRAS
Higher interest rates may cause an inflow of hot
money thus causing a currency appreciation Eval:
This makes exports less competitive leading to a Risk of growth slowdown
slowdown in export sector output, investment Lower domestic consumption and investment
and employment No guarantee commercial banks will lend out
more if returns to savers improve
Rise in interest rates will likely lead to a
contraction in bank lending and make borrowing
more expensive especially for smaller
businesses and households who are dependent
on expensive unsecured credit
Unconventional monetary policy
