Introduction to monetary policy

What is monetary policy?

Changes in the interest rate, money supply and supply of credit by the government or central bank in order to achieve its policy objectives.

Who is responsible for monetary policy?

The central bank e.g. bank of england’s monetary policy committee

What is the base rate?

The rate that all banks base their own interest rates on.

When did the bank of England become independent?

1997 by Brown

What three roles does the BoE have?

• safe and secure payment systems, banks notes etc

• protects the value of money over time, deliver low and stable inflation

• financial stability

Do commercial banks have to change their interest rates according to the base rate?

No, if banks lack confidence about lending or are trying to maintain a certain margin between their saving and lending rates.

What is the current inflation target set by the government?

2%

What is meant by symmetrical target?

Being below target is just as bad as being above.

What must the governor of the BoE do if the inflation target is missed by more than 1%?

Must write an open letter to the chancellor explaining why and what it proposes to do.

Monetary policy committee (MPC)

Consists of 9 members, meet 8 times a year, looks at what it expects inflation to be in two years time NOT now, majority of the MPC’s members is needed.

What 5 things do MPC consider when setting interest rates?

• State of demand

• housing market

• labour market

• inflation from overseas

• trends in the exchange rate

Demand pull inflation

caused by an increase in AD, resources become scare and costs increase so P increases.

Cost push inflation

Caused by an upward shift in the SRAS, occurs when firms respond to rising costs by increasing prices to protect their profit margins.

What are the advantages of monetary policy?

• Impact on economy

• No political bias

• credible monetary policy reduces inflation expectations and increases confidence

What are the disadvantages of monetary policy?

• Uncertainty

• conflicting objectives

• increasing r/i reduces investment

What does the impact of monetary policy depend upon?

• reliable information

• Spare capacity

• Other policy measures like fiscal policy