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Study Notes

Monetary Policy - Central Banks and Monetary Policy

AQA, Edexcel, OCR, IB

Last updated 22 Mar 2021

This note looks at some of the key roles of national central banks such as the Bank of England and the United States Federal Reserve.

What are the key roles of a national central bank?

  • Monetary stability: Conducting monetary policy to ensure stable prices and confidence in the currency. Many countries have an inflation target – often set by the Government for a central bank to achieve. E.g. the UK Government sets the Bank of England an inflation target of 2%. Their aim is to keep the annual rate of consumer prices inflation (CPI) within 1% of the target. This has proved difficult in recent years with UK CPI inflation averaging over 3% since the start of recession in 2008. Inflation returned to the 2% target in December 2013 for the first time in 60 months!
  • Financial stability: This means overseeing the financial system so that there is an efficient flow of savings and loans and confidence in financial intermediaries such as banks. Depositors need to know for example that their savings are safe and that banks and other lenders are acting responsibly.
  • When financial stability breaks down there are damaging economic and social consequences. Consider for example the fall-out from the banking failures in Cyprus in 2013. In December 2013, it was announced that the 18-nation Eurozone is introducing common rules and protections for its banking industry. The idea is to make multi-billion Euro taxpayer-funded bank bailouts a thing of the past. This will include a common banking supervisor and a common deposit guarantee for savers

Monetary stimulus policies

A bold monetary stimulus describes a combination of measures that together form an expansionary monetary policy designed to stabilize confidence, demand and output in a recession and debt-hit economy.

One of the features of the handling of monetary policy in many advanced countries (including the USA and the UK) in response to the global finance crisis has been the willingness of central banks to run loose monetary policies in a bid to prevent one or more economies falling into a persistent deflationary slump.

Since 2008 in the UK we have seen:

  • 1.Policy interest rates (set by the Bank of England) drop from 5.5% in 2007 to 0.5% in March 2009 – they have stayed at that rate ever since
  • 2.The introduction of quantitative easing (QE) starting in 2009 and worth £375bn (as of Jan 2014)
  • 3.Special measures aimed at boosting the ability and willingness of the banking system to finance investment for the business sector such as Project Merlin and the Funding for Lending project
  • 4.A significant depreciation in the external value of the pound / sterling – depreciation represents a competitive boost for export sectors and for businesses in the UK that face competition from imports for the spending of domestic consumers.

Nominal interest rates have been at 0.5% since March 2009 and are likely to remain there for the time being depending on the strength of growth and inflationary pressures. The Bank of England has recently introduced a policy of forward guidance when it comes to setting interest rates.

Under forward guidance, the bank's policy main interest rate will remain at a record low of 0.5% until unemployment falls to 7%, in the hope that this will provide more certainty for borrowers and financial markets.

Forward guidance also operates in the United States. In the US the Federal Reserve has committed itself to maintain near zero interest rates as long as inflation is forecast to remain below 2.5% and unemployment exceeds 6.5%.

A bold monetary stimulus is designed to:

  • Support business and consumer confidence
  • Increase the effective disposable incomes of households with debts such as mortgages
  • Increase demand for interest-sensitive products such as household appliances and new vehicles
  • Help to bring about a depreciation in the exchange rate as hot money flows are reduced
  • Lower the cost of businesses borrowing money to fund their survival or investments

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