Monetary policy intro

Definition

The manipulation of interest, the money supply and exchange rates to influence the level of economic activity.

What are the Uk’s monetary policy goals?

Primary focus is to maintain a low inflation rate of 2% ± 1%.

Who is in charge of monetary policy?

The BoE, who set interest/base rate and control the money supply. Recently, they have also assumed a degree of responsibility for assisting in stimulating growth and employment.

How does the BoE decide how to set interest rates?

Through the Monetary Policy Committee (MPC) they meet monthly to decide the level of interest rates and other changes to policy strategy..

In making their decision, they consider GDP, unemployment, exchange rates, house prices and the level of investment by firms and GDP growth in other countries.

The composition of the MPC

Has 9 members - 4 independent and 5 from within the bank. It’s chaired by the governor of the BoE Andrew Bailey.

It is independent from government, meaning its free from political influence, giving it more credibility.

How is inflation at the 2% target beneficial to consumers, firms and workers?

It gives confidence to:

Consumers - as regard to spending decisions

Firms - as regard to investment decisions

Workers - as regards to wage demands

What impact do interest rates have on AD?

Low rates attempt to stimulate AD through increased consumption, investment and borrowing combined with decreased benefit from saving.

Why did interest rates remain so low for a decade?

Due to extremely low inflation, this was an attempt to prevent deflation.

How are interest rates linked to the exchange rate?

- Global investors with significant sums of money to deposit in banks will seek to place it in the country where they get the best return (where rates are highest)

- If UK suddenly increases interest rates above levels in the US, then investors will move their money here to get the best return.

- They will have to sell dollars and purchase pounds, this increased demand for pounds leads to rising exchange rates.

- This makes exports relatively more price expensive and imports more attractive, worsening balance of payments deficit on current account.

Hot money - definition

Where international funds move around the world chasing the best interest rates.

What are the 3 other monetary policy tools that the BoE has?

1. The money supply

2. Bank lending and credit agreements

3. Quantitative easing

Controlling the money supply: explanation

The bank can expand the supply of notes and coins in the economy, encouraging spending.

However, this must be carefully managed as it reduces the value of money, creating inflationary pressure.

BoE’s rules on bank lending and credit agreements: explanation

If the BoE tighten the rules on how much credit and loan funds banks can make available, this will constrain investment and consumption.

Opposite effect if regulations loosen.

Quantitative easing: Why was it needed?

During the 2008 recession, the BoE would have been expected to cut rates to stimulate activity.

However, with rates already at 0.5%, they had little downward movement to manipulate the economy with.

Banks were also nervous to lend money to firms and individuals, so the BoE sought to boost the funds available for lending to businesses and firms.

Quantitative easing: What is it? What effect has it had?

BoE purchase govt bonds to inject money into the economy. In total, £875 bn of new money has been created by QE since the recession.

Its effects are debatable, nut the recession may have been worse without this response.