1. AS Macro Revision
Monetary Policy and Exchange Rates
Spring 2014

2. We add new resources / links / articles every day
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3. Different Interest Rates in the Economy
An interest rate is the reward for saving and the cost of borrowing
expressed as a percentage of the money saved or borrowed
• There are many different interest rates in an economy
• Interest rates on savings in bank and other accounts
• Borrowing interest rates
• Mortgage interest rates (housing loans)
• Credit card interest rates and pay-day loans
• Interest rates on government and corporate bonds
• Interest rates serve more than one function:
• To compensate for risk (i.e. Risk of default)
• To compensate for inflation which reduces real debt levels
• Central banks such as the Bank of England normally set the price
of money using policy interest rates to regulate the economy

4. Interest Rates on Loans
A rise in interest rates increases the cost of paying back loans taken
out by consumers and businesses
In recent years
the average
mortgage
interest rate on
home loans has
fallen, but the
interest rate on
overdrafts and
credit cards has
actually
increased
towards 20%

5. Negative and Real Interest Rates
An interest rate that is below zero. For real interest rates, this can
occur when the inflation rate is higher than nominal interest rates
• The real rate of interest is important to businesses and
consumers when making spending and saving decisions
• The real rate of return on savings is the money rate of
interest minus the rate of inflation. So if a saver is
receiving a money rate of interest of 6% on his savings,
but price inflation is running at 3% per year, the real rate
of return on these savings is only + 3%.
• Real interest rates become negative when the nominal
rate of interest is less than inflation, for example if
inflation is 5% and nominal interest rates are 4%, the
real cost of borrowing money is negative at -1%.

6. Factors Considered When Setting Policy Interest Rates
The BoE sets policy interest rates consistent with the need to meet
an inflation target set of consumer price inflation of 2%
1.
2.
3.
4.
5.
GDP growth and spare capacity / estimates of output gap
Bank lending, consumer credit figures, retail sales
Equity markets (share prices) and house prices
Consumer confidence and business confidence
Growth of wages, average earnings, labour productivity and
unit labour costs, surveys on labour shortages
6. Unemployment and employment data, unfilled vacancies
7. Trends in global foreign exchange markets (i.e. Is sterling
appreciating or depreciation against other currencies)
8. International data – e.g. Growth rates in economies of
trading partners such as USA and Euro Area

7. Policy Interest Rates in the UK Economy
The policy interest rate is set each month at the meeting of the
Bank of England’s Monetary Policy Committee
When the Bank’s
policy interest
rate changes,
most of the
other loan and
savings interest
rates in the
financial
markets will also
change too

8. Main Challenges Facing the Bank of England
Controlling
price inflation
and keeping
inflation
expectations
low
Supporting a
sustainable /
durable
economic
recovery
Re-balancing
the economy
towards
exports and
investment
Financial
stability –
building a
more secure
banking
system

9. Transmission Mechanism of Monetary Policy
1 / Change in market
interest rates
Normally a change in policy interest rates
feeds through to borrowing/saving rates
2/ Impact on demand
Is there an expansion of
production and employment?
Effect on spending, saving,
investment and exports
3/ Effect on output,
jobs & investment
Rate changes then affect two
of the key macro objectives
4/ Real GDP and Price
Inflation
It can take between 12-24 months for the full effects on real GDP
and the inflation rate after a change in interest rates

10. When Interest Rates Fall
A reduction in interest rates or an increase in the supply of money
and credit is an expansionary or reflationary monetary policy
Cost of servicing loans / debt is reduced – boosting spending power
Consumer confidence should increase leading to more spending
Effective disposable income rises – lower mortgage costs
Business investment should be boosted e.g. Prospect of rising demand
Housing market effects – more demand and higher property prices
Exchange rate and exports – cheaper currency will increase exports
An expansionary monetary policy is designed to boost confidence
and demand during a downturn / recession

11. Limits to the Effects of A Cut in Nominal Interest Rates
Commercial banks
reluctant / unable
to lend
Some interest
rates have
actually risen
High stock
of personal
debt
Low Business &
Consumer
Confidence
Falling real
incomes for
savers

12. Interest Rates and the Distribution of Income
When interest rates fall, there is a re-distribution of income away
from lenders and savers towards borrowers with loans / debt
Incomes of savers
• If the interest on savings is less than inflation,
savers will see a reduction in their real incomes
Incomes of home-owners with mortgages
• If interest rates fall, the income of home-owners
who have variable-rate mortgages will increase
Interest rates on unsecured debt
• Lower interest rates on loans such as credit cards
and bank loans will fall

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14. Quantitative Easing (QE)
• When policy interest rates are at zero or close to zero, there is a
limit to what conventional use of monetary policy can do
• In March 2009 the BoE started quantitative easing for first time.
• The main aim of QE is to support aggregate demand and avoid a
recession becoming a deflationary depression
• Bank of England uses QE to increase the supply of money in the
banking system and encourage banks to lend at cheaper interest
rates – especially lending to small/medium sized businesses
• The Bank does not print new £10, £20 and £50 notes, it uses
money created by the central bank to buy government bonds
• There are doubts about the effectiveness of quantitative easing –
bank lending has struggled to recover since the end of the
recession. At the end of 2013, the QE programme totalled £375bn

15. Some of the Recent Changes to UK Monetary Policy
There have been a number of important changes in the handling of
monetary policy by the Bank of England in recent years
• Quantitative Easing (QE) 2009 – buying bonds to increase
deposits and lending by the banking industry
• Project Merlin (2011) - agreement between banks & Government
to increase lending to small/medium-sized businesses
• Funding for Lending Scheme (2012) – joint policy between
Treasury and the BoE which provides cheaper funding to banks
that increase their loans to households and businesses
• Forward Guidance (2013-14) - under forward guidance, the
Bank’s policy rate will remain at 0.5% at least until unemployment
falls to 7% or until there are clear signs that the amount of spare
capacity in the economy has reached normal levels

16. The Financial Policy Committee of the BoE
In addition to the Monetary Policy Committee, there is a new body
at the Bank of England – the Financial Policy Committee (FPC)
• The FPC is charged with safeguarding financial stability
• The Monetary Policy Committee works through setting policy
interest rates and the scale of quantitative easing (QE)
• The Financial Policy Committee can operate directly on the supply
and price of credit in the banking system
• The FPC has the power to alter loan-to-value ratios (e.g. Ratio of
a mortgage loan to house prices)
• It can also change the cash reserve requirements or capital
buffers for commercial lenders – e.g. They might insist that banks
keep a higher proportion of new deposits in cash rather than lend
them out to businesses and households

17. Forward Guidance when Setting Interest Rates
• Forward Guidance was introduced by
Mark Carney in August 2013
• It has been signalled that the Bank of
England will leave their policy interest
rates unchanged as long as the
unemployment rate is above 7.0% and
inflation is under control
• The main aim is to build confidence by
signalling that interest rates would stay
at low levels for some time
• In February 2014, Mark Carney
signalled that forward guidance would
evolve – LFS unemployment is not the
sole data measure to be used

18. Interest Rates, Inflation and Unemployment
The Bank of England’s main focus is on controlling inflation – but
they must also consider the wider economic picture
For most of the
time that
interest rates
have been at
0.5%, inflation
has been above
target. Will
interest rates
rise in 2014?
Both inflation
and
unemployment
are falling

19. We add new resources / links / articles every day
to our Economics blogs
Follow this link for the AS Macro Blog on Tutor2u
www.tutor2u.net/blog/index.php/economics/categories/C59

20. Credit Policy (Monetary Policy)
Credit is created by the banking system – the UK economy along
with many other countries has a high stock of unpaid debt
• Conventional monetary policy focuses on the effects of
• Changes in interest rates for borrowers and savers
• Changes in the supply of money in the economy
• Changes in the value of a country’s exchange rate
• Credit policy is becoming important in many countries –
affecting economic growth / recovery
• Policies that impact on credit supply
• Reforms to the banking system

21. The Credit Squeeze – Banks and Business Lending
• Commercial banks have lowered their
willingness to take risks when lending
• Rise in non-performing loans (bad
debts) which have contributed to
heavy losses - Total loan write-offs
were over £11bn in 2012
• Higher deposits and tougher checks
to get a mortgage
• New (tougher) global rules (known as
Basel III) on the amount of capital and
liquidity that banks must hold
• Many businesses in the UK have
become “credit constrained”

22. Evaluation Points on Interest Rates & Monetary Policy
• Time lags should be considered when
analyzing effects of interest rate changes
• Monetary policy not an exact science –
consumers and businesses don’t always
behave in a textbook way!
• Many factors affect costs and prices which
can change inflation risks in a country
• Monetary policy does not work in isolation!
Consider how fiscal policy is affecting the
economy
• Objectives of monetary policy can change –
the USA Federal Reserve’s mandate is
“maximum employment, stable prices, and
moderate long-term interest rates”

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24. The Exchange Rate
The exchange rate is the rate at which one currency can be
exchanged for another i.e. £1 buys $1.60
£ has been appreciating
against the US dollar in
the second half of 2013
A depreciation
of the exchange
rate means that
£1 buys fewer
US dollars ($)
The UK operates
with a floating
exchange rate –
the external
value of the
currency is
determined
purely by market
forces of supply
and demand for
a particular
currency.

25. How a Weak Currency can affect Macro Objectives
Changes in the exchange rate affect demand for exports and
imports; real GDP growth, inflation, business profits and jobs
Inflation
• A fall in a currency leads to a rise in import prices
• Causes a rise in cost-push inflationary pressure
Export demand and trade balance
• Weaker currency makes exports cheaper overseas
• Rising export sales & a stronger trade balance
Real GDP and jobs
• Rise in exports and fall in imports will increase AD
• Higher export profits is boost to the labour market

26. Economic Effects of a Currency Depreciation
When the pound depreciates against the US dollar
It makes UK import prices RISE
It makes UK export prices FALL
Changes in import and export prices will affect demand
Import sales will CONTRACT
Export sales will EXPAND
This will have an effect on a number of key economic indicators
Domestic production 
Trade deficit 
Domestic jobs 

27. Evaluating the Effects of a Currency Depreciation
In theory a depreciation of the exchange rate provides a boost to
aggregate demand and economic growth ....but this depends on..
1. The length of time lags as consumers and businesses respond
2. The scale of any change in the exchange rate i.e. a 5%, 10%, 20%
3. Whether the change in the currency is short-term or long-term –
i.e. is a change in the exchange rate temporary or likely to persist
4. How businesses and consumers respond to exchange rate
changes – the value of price elasticity of demand is important i.e.
will there be a large change in demand for exports & imports?
5. The size of any second-round multiplier and accelerator effects
6. When the currency movement takes place – i.e. Which stage of
an economic cycle (recession, recovery etc)

28. The Effects of a Currency Appreciation
A currency appreciation makes
exports more expensive & is likely
to lead to an inward shift of AD
GPL
A currency appreciation makes
imports cheaper & likely to cause
an outward shift of AS
GPL
AS
AS1
GPL1
GPL1
GPL2
GPL2
AD1 GPL3
AD2
Y2
Y1 Real GDP
AS2
AD1
AD2
Y2 Y3 Y1 Real GDP

29. The Exchange Rate and Unemployment
• An exchange rate appreciation causes a
slower growth of real GDP because of a fall
in net exports (a reduced injection) and a
rise in the demand for imports (an
increased leakage in the circular flow).
• A reduction in demand and output may
cause job losses as businesses seek to
control their costs.
• Thus a higher exchange rate can have a
negative multiplier effect on the economy.
• Some industries are more exposed to
currency fluctuations – e.g. sectors where a
high % of output is exported and where
demand is price sensitive (price elastic)

30. Get help on the AS
macroeconomics course
using twitter
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