You are: Home > Economics bank > Monetary Policy > Monetary Policy Committee > Worksheets > Worksheet 1

Monetary Policy - Monetary Policy Committee

Worksheet 1 - Inflation - what links interest rates to inflation?

The aim of this worksheet is to look at the monetary transmission mechanism and how the changes in interest rates made by the Monetary Policy Committee of the Bank of England feed through to inflation. It is designed to assess knowledge and understanding of the main issues.

1. What are the three stages in the monetary transmission mechanism?

(6 Marks)

2. Fill in the blanks in the diagram below that illustrates the monetary transmission mechanism.

The transmission mechanism - linked to larger version

View larger version.

(4 marks)

3. If the Monetary Policy Committee raise the interest rate, which of the following would you expect to happen as a result? Circle either yes or no.

Banks and building societies increase their mortgage rate	Yes / No
The price of gilt-edged securities increase	Yes / No
The rate of increase of house prices slows down (or prices even fall)	Yes / No
The value of sterling falls	Yes / No
Share prices increase	Yes / No
Investment by firms increases	Yes / No
Government expenditure increases	Yes / No

(7 Marks)

4. Show the impact of an increase in the rate of interest on the diagrams below. The diagrams show equilibrium in terms of aggregate demand and supply according to Keynesian and Classical economists. Write a brief explanation of the effects you are describing.

Equilibrium of aggregate demand and supply according to Keynesian economists

Equilibrium of aggregate demand and supply according to Classical economists

(6 Marks)

5. Fill in the blanks below to give an appropriate description of the monetary transmission mechanism.

The monetary transmission mechanism is the process by which changes in _______________ _____________ affect ________________. The ________________ ________________ ________________ is the committee of the Bank of England that sets ________________ ________________ for the UK. An increase in the official interest rate set by the MPC will tend to lead to other interest rates ________________ as well.

The higher interest rate will also affect the price of other assets like ________________ and ________________ as well. The price of gilt-edged securities will tend to fall as they are ________________ related to interest rates.

An increased interest rate will tend to lead to a(n) ________________ of the exchange rate. This will ________________ the price of exports and ________________ the price of imports.

These changes will feed through to aggregate demand and an increased interest rate will tend to lead to a(n) ________________ in aggregate demand. This should ________________ domestic inflationary pressure and therefore help to reduce the level of ________________.

(14 Marks)

Total Marks = 37