Monetary Policy

Monetary Policy

Involves making decisions about interest rates, the money supply and exchange rates. Its aims are to ensure price stability, promote economic growth and reduce unemployment

Contractionary monetary policy

This involves reducing AD using high interest rates, restrictions on the money supply and a strong exchange rate

Expansionary monetary policy

This involves increasing AD using low interest rates, fewer restrictions on the money supply and a weak exchange rate

How interest rates are set

The Monetary Policy Committee (MPC) of the Bank of England sets interest rates in order to meet the government inflation target.

How the Bank of England achieves stability and credibility

They are independent of the government and are held accountable for their decisions.

Effects of an increase in interest rates

• Less borrowing

• More saving

• Less investment by firms

• Less consumption

• A decrease in exports

• An increase in imports

• Less confidence amongst consumers and firms

A decrease in interest rates will have the opposite effects.

How interest rates affect exchange rates

When interest rates are high:

• Big financial institutions want to buy the pound to take advantage of the high rewards for savers (‘hot money’)

• An increased demand for the pound means that its exchange rate rises

• Exports become more expensive and imports become cheaper

Time lags after changing the Bank Rate

• One year for maximum effect on firms to be felt

• Two years for maximum effect on consumers to be felt