Question

The subject is Macroeconomics: I’d like the answer to be a rather long rant instead of short and tangible.

Great Britain is for the third year in a row preparing for Brexit. The great insecurity for the future has introduced great fluctuations in their exchange-rate and of fear capital flight. Therefore, the Bank of England has chosen to increase the rent of allowance.

1) Analyse how an increase in rent of allowance will affect the exchange rate and the economy of Great Britain.

2) What will it mean for this kind of policy, if the large trading partner, the USA, will start to run a more expansive money policy?

Answer 1

1. The effects of this monetary policy on the exchange rate and the economy of Britain are:

• Liquidity Trap – This occurs when a cut in interest rates fail to stimulate economic activity. e.g. because of low confidence or banks don’t want to pass base rate cut onto consumers.
• Difficult to control many objectives with one tool – interest rates. For example, a rise in oil prices causes cost-push inflation and lower growth. The Bank could increase interest rates to reduce inflation, but, it would cause economic growth to fall as well. In 2009, inflation rose to rising oil prices, but the economy was also in recession; the Bank decided to ‘allow’ the temporary inflation and concentrate on economic recovery.
• Changing interest rates affects the exchange rate. Tight monetary policy causes an appreciation in the exchange rate which will make exports less competitive.
• Interest rates may affect some parts of the economy more than others. e.g. higher interest rates increase the disposable income of people with savings. But, could cause homeowners to be unable to afford their mortgages.
• Time lags – If the Bank of England change base rates, it can take up to 18 months for the effects to filter through the economy. For example, if people have a two-year fixed mortgage, they will not notice until they remortgage. This means the Bank needs to predict future inflation so that they can change interest rates in anticipation.

2. The effect of an expansive economic policy by United States would be :

• It takes time to recognize that there is a problem in the economy and react appropriately. Second, even if the interest rate changes quickly when OMOs are carried out, the impact of the interest rate change takes time.
• It takes time for changes in the overnight rate to pass through to other interest rates. Even once other interest rates have adjusted, the investment response to a new interest rate takes time
• Eventually, this changes the interest rate charged for home loans, too