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MCQ Revision Question - Inflation Targets

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​Here is an interesting A level multiple choice question about what is likely to happen to interest rates and the exchange rate if the central bank of a country with a floating exchange rate opts to lower their inflation target.

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Transform Britain | Paul Mason Interviews John McDonnell

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Quantitative easing explained - in the back of a cab... | Paul Mason on the news

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Paul Mason explains the theory of quantitative easing in under four minutes. Subscribe to Channel 4 News: http://bit.ly/1sF6pOJ More from Paul Mason: http://bit.ly/1zwEPtg Read more here: http://bit.ly/1y2YvOX Top stories: http://bit.ly/1wdbIG1

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This sort revision video looks at how quantitative easing works in the UK and considers some of the arguments for and against QE as a form of unconventional monetary policy.

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1. Monetary policy function
Setting of the main monetary policy interest rate

Quantitative easing

Exchange rate intervention (managed/fixed currency systems)

2. Financial stability & regulatory function
Supervision of the wider financial system

Prudential policies designed to maintain financial stability

3. Policy operation functions
Lender of last resort to the banking system

Managing liquidity in the commercial banking system

4. Financial infrastructure provision function
Overseeing the payments systems used by banks / retailers / credit card companies

Debt management

Handling the issue and redemption of issues of government debt

Current objectives of UK monetary policy
Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the Government's inflation target, which the Bank seeks to meet through the decisions taken by the Monetary Policy Committee (MPC).

The Bank of England has been independent of the UK government since May 1997. The current governor is Mark Carney.
An Era of Extraordinary Monetary Policy
Central Banks of many advanced countries have made extraordinary sustained use of expansionary monetary policy in recent years:

Policy interest rates approaching the zero bound and remaining there (e.g. 0.5% in the UK and in the USA)

Negative policy rates in some countries (e.g. Japan, Sweden, Denmark and Switzerland)

Huge rise in the scale of quantitative easing (QE) designed to increase the base supply of money

Increasing use of exchange rate (currency) intervention as an instrument of monetary policy (i.e. a move towards managed floating)
Central banks - key terms

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Central Banks (Financial Economics) | tutor2u Economics

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Monetary policy function Setting of the main monetary policy interest rate Quantitative easing Exchange rate intervention (managed/fixed currency systems) Financial stability & regulatory function Supervision of the wider financial system Prudential policies designed to maintain financial stability Policy operation functions Lender of last resort to the banking system Managing liquidity in the commercial banking system Financial infrastructure provision function Overseeing the payments systems used by banks / retailers / credit card companies Debt management Handling the issue and redemption of issues of government debt Current objectives of UK monetary policy Monetary stability means stable prices and confidence in the currency.

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MCQ Revision Question - Quantitative Easing

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This exam multiple choice question tests student understanding of the likely effects of a central bank using QE on bond prices and the exchange rate.

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Cyprus has agreed a 10bn euros bailout with the European Union and the International Monetary Fund (IMF) in an attempt to stave off the collapse of its banking sector and the wider economy.
What has been agreed?
Cyprus has agreed to a significant restructuring of its banking sector, along with other measures such as tax rises and privatisations. The measures are designed to raise billions towards the bailout, but protect bank customers with deposits of 100,000 euros or less.

Cyprus's second largest bank - Laiki Bank - will be closed down and deposits above 100,000 euros moved into a "bad bank". Deposits below 100,000 euros will be moved into Bank of Cyprus, the country's biggest bank, which is being significantly restructured.

Deposits at Bank of Cyprus of more than 100,000 euros are being frozen.

At both banks, deposits above 100,000 euros will be used by the government to contribute billions towards the bailout. It is not clear how much of the money will be taken, but a government spokesman has suggested customers should expect about 40% of the balance to be converted into bank shares.
What about the bank levy?
In the original EU-IMF deal, all customers of Cypriot banks were to face a one-off tax on their deposits, starting at 6.75% for the smallest deposits.

That was designed to raise 5.8bn euros towards the cost of the bailout. But it proved hugely unpopular with the Cypriot public and was voted down by Cyprus's parliament.

There is no bank levy in the new deal, but the bank restructuring measures mean deposits over 100,000 euros will effectively be used to pay the bulk of the 5.8bn euro bill.

The measures cannot be voted down by Cyprus's parliament, as new bank restructuring laws have already been agreed and voted through by MPs.
Why are there capital controls?
After being closed for almost two weeks, Cyprus' banks have reopened - but with strict controls on how much money can be withdrawn.

This is to prevent a bank run, where customers try to withdraw all their money at once due to a lack of confidence in the banking sector. In the past, bank runs have caused banks to collapse.

In Cyprus, customers are limited to withdrawing 300 euros a day, taking no more than 1,000 euros in cash on trips out of the country, and transferring no more than 5,000 euros a month on debit or credit cards.

Bigger transactions need the approval of Cypriot authorities.

The measures were due to stay in place for just a few days, but Cypriot authorities are already indicating that they are likely to keep them in place for longer. Iceland introduced temporary capital controls in 2008, which are still in place today.
Are the UK operations of Cypriot banks affected?
Bank of Cyprus UK has 50,000 UK customers. Although it is a subsidiary of Bank of Cyprus, it is a separately incorporated UK bank and depositors are protected by the UK's Financial Services Compensation Scheme (FSCS), which covers savings up to £85,000. It said the crisis in Cyprus would have no effect on its deposits.

Laiki Bank has four branches in Britain and serves 13,000 customers.

Unlike Bank of Cyprus UK, its UK operations are directly controlled from Cyprus, and so are not covered by the FSCS. It says deposits up to 100,000 euros are guaranteed and customers are free to make withdraws if they wish.

However, the UK Finance Minister, George Osborne, says the UK government is in talks with Cypriot authorities to find "a British solution" to Laiki's UK branches.
So is the crisis over?
Not necessarily. In the short term, the risk of the Cypriot banking sector collapsing has receded, and the bailout funds will allow the government to pay its own debts and undertake the restructuring of the banks without facing economic collapse or exiting the euro.

But in other respects the outlook is less certain. Cyprus must enact tough austerity measures to rebuild its economy, and regain trust among investors in its banking sector and government. It is unclear whether the Cypriot public, angered by how the crisis has been handled so far, will support that.

It is also unclear how much trust is left in Cyprus's banks, and so when fears over a bank run will recede.

Finally, the whole episode has damaged confidence in European authorities' ability to handle economic crises.
What went wrong in Cyprus?
Before the financial crisis struck in 2008, Cyprus was seen to have a healthy economy, with high growth, low unemployment and sound public finances.

But during the good years, the island's banking sector grew rapidly. By 2011, the IMF reported that their assets - which include all the loans they have made - were equivalent to 835% of annual national income, or GDP. A chunk of that is down to foreign-owned banks, but those that are Cypriot had made loans to Greek borrowers worth 160% of Cypriot GDP.

When Greece became engulfed in crisis in 2010, Cypriot banks were hit hard, and the government did not have the money to bail them out itself. Government finances have been further weakened by slow economic growth and international lenders have stopped offering loans.

Negotiations on a bailout with the EU were delayed by the previous socialist government. President Nicos Anastasiades, a conservative who favoured a swift agreement with Europe, assumed office in late February.
Why was a bank levy considered?
When countries get an international bailout, they are often expected to contribute to the solution by raising funds themselves, usually by increasing taxes or selling state-owned assets.

The levy on bank deposits was designed to play the same role. It was intended to reduce the size of the bailout and therefore the amount of new debt Cyprus had to take on.

But there is almost certainly a political aspect, too. In the eurozone, there are concerns about money-laundering in Cyprus and the presence of large amounts of Russian-owned money in the banks. Germany is reputed to be especially unhappy about the idea of using European taxpayers' money to rescue them.

Experts say the decision to target ordinary savers came about because Cypriot banks have fewer private bondholders than banks in other eurozone countries. In the Greek bailout, it was private bondholders who had to take a "haircut" - a slice out of their investment.

However, the deal provoked outrage in Cyprus, parliament promptly voted against it, and it is increasingly seen as a blunder by European and Cypriot authorities.

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Cyprus has agreed a 10bn euros bailout with the European Union and the International Monetary Fund (IMF) in an attempt to stave off the collapse of its banking sector and the wider economy. What has been agreed? Cyprus has agreed to a significant restructuring of its banking sector, along with other measures such as tax rises and privatisations.

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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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Monetary Policy - Central Banks and Monetary Policy | tutor2u Economics

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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%.