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Policy Instruments (AS)

Monetary policy: Bank Rate and the transmission mechanism

  • 3 things to know
  • AS Units 1 and 2

Overview

Recall questions on Bank Rate and the transmission mechanism.

What you need to know

Answer each one before you reveal it.

Your recallNot started
Key term

Explain the asset price channel of a rise in Bank Rate.

Key term

Why is the time lag on monetary policy a problem for the Monetary Policy Committee?

Key term

How does a change in Bank Rate feed through to households and firms?

Questions from this subtopic

Each one with the model answer underneath.

  1. 1

    What is Bank Rate?

    Model answer

    Bank Rate, also called the base rate, is the interest rate the Bank of England pays on the reserves that commercial banks hold with it, and it anchors interest rates across the economy.

  2. 2

    How does a change in Bank Rate feed through to households and firms?

    Model answer

    Commercial banks adjust their own lending and savings rates broadly in line with it, so mortgage payments, loan costs and the return on saving all change.

  3. 3

    Explain how an increase in Bank Rate affects consumption.

    Model answer

    Borrowing becomes dearer and saving more rewarding, while higher mortgage payments cut the disposable income of borrowers, so households cut back on spending, especially on durables bought on credit.

  4. 4

    Explain how an increase in Bank Rate affects investment.

    Model answer

    The cost of financing capital projects rises and fewer projects clear the higher required rate of return, so planned investment falls, an effect reinforced by weaker expected demand.

  5. 5

    Explain how a rise in Bank Rate is transmitted through the exchange rate.

    Model answer

    Higher returns attract capital inflows, raising demand for the currency so that it appreciates, which makes imports cheaper and reduces imported inflation while making exports dearer and cutting net exports.

  6. 6

    Explain the asset price channel of a rise in Bank Rate.

    Model answer

    Higher interest rates reduce the present value of future returns, so bond, share and house prices tend to fall, and the resulting negative wealth effect makes households less willing to spend.

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