Problem Focused Exercise: Monetary Policy- how is it decided?
1
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 Committee’s decision.
Task A
Read the short extract How Monetary Policy Works from the Bank of England’s
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) What economic objectives do interest rates affect?
(3) 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 Bank’s 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
2
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?
3
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?
4
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)
Case (b)
LRAS
LRAS
P
SRAS
SRAS
P5
P2
P4
P3
P1
AD2
AD2
AD1
AD1
Y1
Y2
Y
Copyright: Embedding Threshold Concepts Project
Y3
Y4
Y
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?
5
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 (¼ 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?
6
Feedback Task 1 (cont) Basic
Circular Flow of Income
Decreased
Savings &
Imports
T
Rise in consumption
Increased
Investment &
Exports
G
Firms
Households
Rise in income
With an decrease in interest rates there is:
•An increases in injections. Investment and exports increase, incomes then
increase as jobs are created and this increases consumption. There is a
multiplier effect with the increase in consumption.
•A reduction in withdrawals. Savings and imports fall, there is an increase in
incomes and this increases consumption. There is a multiplier effect 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
7
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 (¼ 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?
8
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.
3.
4.
5.
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.
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.