economics theme 2 : monetary policy (demand side policies)

monetary policy definition

influences the decisions that we make about how much we save, borrow and spend

who decides interest rates

• monetary policy committee (MPC)

• independent of the government

how many rates of interest are there

• multiple rates but the base rate drives it

• they tend to move in the same direction

what approach does the Bank of England tend to use

• gradualistic approach

• believes that a series of small movements in interest rates is a more effective strategy rather than sharp jumps in the cost of borrowing money

• aim is to gradually increase the cost of borrowing money and increase the incentive to save so that the pace of growth moderates and the economy can continue to grow without causing rising inflation

contractionary monetary policy explained

• increased base rate by Bank of England

• high street banks increase savings rates → higher rates of return in the UK → increase in demand for the pound from overseas investors → increase in price of UK exports and fall in price of imports → fall in AD

• high street banks increase cost of borrowing → firms incentive to borrow reduces → firms with overdrafts see their costs rise → firms ability to invest falls → fall in AD

• high street banks increase savings rates → consumers incentive to save increases → higher saving leads to lower spending → fall in consumption → fall in AD

expansionary monetary policy explanation

• decrease in base rate by Bank of England

• high street banks decrease savings rates → lower rates of return in the UK → decrease in demand for the pound from overseas investors → decrease in the price of UK exports and rise in price of imports → rise in AD

• high street banks decrease the cost of borrowing → firms incentive to borrow increases → firms with overdrafts see their costs fall → firms ability to invest rises → rise in AD

• high street banks decrease savings rates → consumers incentive to save decreases → lower rates of saving leads to higher spending → increase in consumption → rise in AD

5 factors considered when setting interest rates

• state of demand

• housing market

• labour market

• inflation from overseas

• trends in the exchange rate

state of demand explanation

is AD too strong?

housing market explanation

what are the economic signals coming from the housing market? e.g if house prices are rising too rapidly, this might feed into increased consumer demand and the risk of a surge in demand-pull inflation

labour market explanation

are there inflationary signals coming from the labour market in the form of acceleration in wages and average earnings week above the growth of labour productivity?

inflation from overseas explanation

is there a risk from import costs such as a rise in oil prices?

trends in the exchange rate explanation

what is happening and what is projected to happen to the sterling exchange rate?

quantitative easing definition

the act of deliberately increasing the supply of money in an economy by a central bank

QE explanation

• Bank of England increases money supply

• buy assets with the ‘new’ money

• buy high street bank bonds → high street banks have more liquidity → high street banks now able to lend to firms and consumers → increase in investment and consumption so increase in AD

• buy gov bonds → gov has more liquidity → gov can increase spending → increase in gov spending means increase in AD

6 evaluations of monetary policy

• gradulaist approach

• time lag

• external shocks

• high street bank response

• firms and consumer response

• MPC data

gradualist approach explanation

• Bank of England doesn’t want to shock the economy, trying to gently change consumers behaviour

• but sometimes a shock is needed, sometime sees to be more aggressive (less gradual, change of more than 0.25%)

time lag explanation

• takes a full 2 years before the effects of interest rates are seen int he economy

external shocks explanation

• cannot know when an external shock will occur

• therefore difficult to respond to them as they are unexpected

• examples : covid 19, financial crisis (2008) and war on Ukraine

high street banks response explanation

• Bank of England is high street banks lender of last resort

• but there’s no law that you have to change the interest rates

• policy would be useless is the high street banks don’t respond (no change in AD)

• full effect of policy might not be felt if high street banks are sticky to out their rates up

firms and consumer response explanation

• just because the incentive to save increases, doesn’t mean all consumers will save, some will still be spending

• even if interest rates increase and a firms incentive to borrow decreases, some firms will still take out loans, for example if they need tog et a new van to make deliveries as theirs has broken

MPC data explanation

• if the MPC uses inaccurate GDP data, they could make an inaccurate judgement, which could then worsen the economy