Definition: Monetary policy involves the central bank altering the supply of money in the economy and/or manipulating interest rates.
Bank of England (BoE): Actions to influence the amount of money in the economy and the cost of borrowing.
European Central Bank (ECB): Decisions taken by central banks to influence the cost and availability of money.
Federal Reserve (FED): Actions and communications to promote maximum employment, stable prices, and moderate long-term interest rates.
Monetary Policy Setting
Government Sets Policy (Pre-1997 UK): The government sets the policy and decides on measures to achieve it.
Government Sets Targets, Central Bank Independent (Current UK): The government sets the policy targets, but the central bank has independence in deciding monetary policy.
Central Bank Independent (European Central Bank): The central bank has independence both in setting policy targets and running monetary policy.
Inflation Targets
Many countries use inflation targets as a key part of their monetary policy.
Examples of countries and their inflation targets:
Australia: 2–3% (Average over the business cycle)
Brazil: 3.5% (Tolerance band of ±1.5%)
Canada: 2% (Tolerance band of ±1%)
Chile: 3% (Tolerance band of ±1%)
Czech Republic: 2% (Tolerance band of ±1%)
Eurozone: 2% (Average for eurozone; over medium term)
Hungary: 3% (Tolerance band of ±1%; over medium term)
Iceland: 2.5% (Tolerance band of ±1.5%)
Israel: 1–3%
Japan: 2%
Mexico: 3% (Tolerance band of ±1%)
New Zealand: 2% (Tolerance band of ±1%)
Norway: 2% (Close to 2% over time)
Peru: 2% (Tolerance band of ±1%)
Poland: 2.5% (Tolerance band of ±1%)
South Africa: 3–6%
South Korea: 2%
Sweden: 2% (1–2 year horizon; tolerance band of ±1%)
Switzerland: <2% (Close to 2%)
Thailand: 1–3% (Tolerance band of ±1.5%)
UK: 2% (Forward looking; tolerance band of ±1%)
USA: 2% (Average rate of 2% over time; consistent with dual mandate of stable prices and maximum employment)
Monetary Policy Tools
Controlling Interest Rates:
Announcing changes in interest rates.
Backing up announcements with repo market operations.
Controlling the Money Supply:
Open market operations.
Quantitative easing/tightening.
Techniques to Control Interest Rates
Bank Rate: The interest rate the Bank of England charges when lending to commercial banks; also the interest rate it pays to commercial banks holding reserves with the BoE.
The central bank can choose the rate of interest to charge, which will have a knock-on effect on other interest rates throughout the banking system.
Pass-through Effect: The effect on other interest rates in the economy when the central bank changes its rate(s).
When Bank Rate is increased, the base rate charged by commercial banks increases, too.
Changes in central bank interest rates, however, will not necessarily have an identical effect on other interest rates (e.g., mortgage rate).
Techniques to Control Money Supply
Open-Market Operations (OMOs): Sale (or purchase) by the authorities of government securities (bonds or bills) in the open market in order to reduce (or increase) money supply.
To reduce the money supply, the central bank sells government securities.
When people buy securities, they draw on their bank accounts.
Thus, banks’ reserve balances with the central bank are reduced.
Banks reduce advances, and the money supply contracts.
To increase the money supply, the central bank buys government securities.
In response to sluggish demand after the Global Financial Crisis and during the Covid-19 pandemic.
Interest rates already at historical lows.
The process became known as quantitative easing.
Quantitative Easing: A deliberate attempt by the central bank to increase the money supply by buying large quantities of securities (private-sector debt or government bonds) through OMOs.
How quantitative easing works:
Central bank creates money digitally (‘central bank reserves’) to purchase securities.
This increases bond prices, but their ‘yield’ (that is, coupon rate/bond price) falls.
Yields on government bonds act as a benchmark interest rate for all sorts of other financial products (e.g., interest rates on household mortgages).
In turn, those lower interest rates lead to higher spending in the economy and boost AD.
Impact of Monetary Policy
Effect of an Increase in Interest Rates:
Increase return on savings, discourage consumption, reduces AD.
May discourage business investment, reduces AD.
Adds to costs of production, cost of living (increases mortgage repayments).
Drives up the exchange rate, by encouraging money inflow from abroad.
The Bank of England’s Approach
Targets inflation.
Monetary policy based on forecast inflation in 24 months’ time.
Deliberations of the Monetary Policy Committee (MPC).
MPC meets eight times per year.
Publishes a quarterly Monetary Policy Report with projections for inflation and real GDP growth for the next 3 years.
If projected inflation in 24 months’ time is off target, MPC changes interest rates.
Inflation Targeting in the UK
How successfully has the inflation target been met?
UK introduced inflation targeting in 1992.
Inflation virtually within target 1993-2007.
After 2007-8 more variation, but still small by historical standards.
Response to rise in inflation in 2022–23
Inflation soared in 2022 reaching at 11.1% by October – more than 9% above target.
BoE raised the Bank Rate, from 2.25% in September 2022 to 5.25% in August 2023, where it remained for a year, despite inflation falling.
Since August 2024, BoE lowered the Bank Rate four times to 4.25% where it currently stands.
Lecture Summary
The Bank of England administers monetary policy to achieve the 2% inflation target set by the Government.
In the short term, the authorities can use monetary policy to influence aggregate demand by altering money supply and/or changing interest rates.
After the global financial crisis and then again in response to the COVID-19 pandemic, many central banks engaged in quantitative easing to increase aggregate demand.