Economics for Business I - Macroeconomics - Lecture 8

Monetary Policy

Introduction

• This lecture introduces monetary policy, discusses its tools, and describes inflation targeting in the UK.

Monetary Policy Definition

• Monetary policy involves the central bank altering the supply of money in the economy and/or manipulating interest rates.
• Bank of England (BoE): Monetary policy influences how much money is in the economy and the cost of borrowing.
• European Central Bank (ECB): Monetary policy concerns decisions taken by central banks to influence the cost and availability of money.
• Federal Reserve (FED): Monetary policy in the United States comprises actions and communications to promote maximum employment, stable prices, and moderate long-term interest rates.

Monetary Policy Setting

• Pre-1997 (UK): Government sets the policy and decides measures to achieve it.
• Today (UK): Government sets policy targets, but the central bank has independence in deciding monetary policy.
• European Central Bank: Central bank has independence in setting policy targets and running monetary policy.

Inflation Targets

• Various countries have different 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 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, and with interest rates already at historical lows, quantitative easing was implemented.
• 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:
  • Increases return on savings, discourages 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 is 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 was virtually within target from 1993-2007.
  • After 2007-8, there was more variation, but still small by historical standards.
• Response to rise in inflation in 2022–23:
  • Inflation soared in 2022, reaching 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

1. The Bank of England administers monetary policy to achieve the 2% inflation target set by the Government.
2. In the short term, the authorities can use monetary policy to influence aggregate demand by altering money supply and/or changing interest rates.
3. 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.