Monetary Policy Notesheet

3.6 Monetary policy

“A policy that aims to control the total supply of money in the economy to try to achieve the government’s economic objectives, particularly price stability”

Monetary Policy is controlled by the MONETARY POLICY COMMITTEE at the Bank of England.

The inflation target is 2% + - 1% CPI

If inflation is high the BOE tends to raise the base rate.

The main tool of Monetary policy is the BASE or Bank rate - the rate of interest set by the Bank of England (BOE). The Bank of England acts as the “bankers’ Bank” i.e. Banks can borrow from the BOE. If their lending becomes more expensive banks will also raise the rate of interest they charge to their customers (consumers and businesses)

How does monetary policy work?

• Changes in interest rates affect demand in the economy

• Demand is affected in a number of ways

• Let’s consider how an increase in interest rates affects the economy

Consumer spending:

• Saving will increase due to the increased returns on saving making saving more attractive

• Borrowing will decrease (eg on ‘big ticket items’ such as cars, furniture) as it is more expensive to borrow making it less affordable

• Mortgage payments will increase leaving families with less discretionary income to spend and discourages people to become homeowners

• Consumer spending falls

IMPACT depends on size of rise/whether people continue to spend and just reduce saving/whether they cut back on imports or domestically produced goods/confidence/% of pop that have mortgages and % who have fixed rate mortgages/% of pop who borrow v save/whether or not banks pass on interest rate changes/Mortgage interest payments can be a significant proportion of household outgoings, so a rise in these may lead to a significant fall in consumer spending.

Investment spending:

• Loans to fund investment are more expensive

• Interest charges on existing business loans will increase meaning increased costs and reduced profits. Retained profit is a major source of funding for investment

• Saving becomes more attractive compared to the higher risk investment.

• Investment spending falls

Extent depends on size of rise/confidence/state of the economy at the time/other factors (investment decisions are not just based on the cost of borrowing)

Exports and imports:

• An increase in interest rates will increase the value of the pound (we will look at why next year)

• An appreciation of the £ means our exports become expensive and imports cheaper

• Cheap imports of stock and raw materials reduce cost-push inflationary pressure, less demand for our exports will lower demand-pull inflation

• Exports fall & imports rise

Extent depends on the size of the rise/its impact on the ER (what is happening to IRs elsewhere)/PED of X and M

So a rise in interest rates causes inflation to fall because:

• There will be a fall in AD (since AD = C+I+G+X-M) reducing demand-pull inflation

• There will be an increase in AS (from cheaper imports) reducing cost-push inflation (only use this argument if you have talked about exchange rates)

However, people may not save more if the MPC interest rates rise is so small that it is not effective/state of economy etc (see previous points made)

Overview – in simple terms

• If inflation is rising above 2% – MPC will increase the base rate

• Raising interest rates = contractionary monetary policy

• If inflation is falling below 2% - MPC will reduce the base rate

• Lowering interest rates = expansionary monetary policy

The Bank of England can also use quantitative easing as part of monetary policy

• The Central Bank makes more money available for financial institutions to led to households and firms.

• When households spend more, firms receive higher incomes encouraging them to produce more. It is also easier for firms to borrow to invest and expand.

• This leads to more workers being employed and greater spending still (the multiplier effect)

• This allows the achievement of economic growth and low unemployment