Monetary Policy

Key Terms
Monetary policy: The process by which the monetary authority of a country controls the demand and supply of money.

Real Interest rates: The nominal rate of interest minus the rate of inflation.

Nominal interest rates: Interest rates not adjusted for inflation.
Theory

Background on Monetary Policy


Functions of Money


1) A medium of exchange - Money is an asset which is accepted in exchange for goods and services.

2) A store of value or wealth - Money can be accumulated over time, holding its purchasing power into the future if we choose not to spend it today.

3) A unit of account - Money provides a means of expressing value, allowing people to compare the relative values of goods and services via their quoted prices.

4) A standard of deferred payment - In developed economies, goods are often purchased on credit, with the amount to be repaid in the future. This function allows people to delay paying for goods or settling debts, since we can be reasonably confident about the future value and purchasing power of money.


Main measures of the money supply


M0 (Narrow money) – Consists of sterling notes and coins

M4 (Broad money) – Consists of sterling notes and coins, sterling deposits held by the private sector (for saving / transaction purposes) and includes new money created by lending.


U.K Monetary policy framework


In 2009 Bank of England (BOE) embarked on a programme of ‘Quantitative easing’ to boost money supply to prevent deflation. The main instrument is the interest rate set by the MPC.

The main objectives of UK. monetary policy are:

  • price stability – low inflation

  • growth and employment


    • Types of Monetary Policy

    Loose Monetary Policy


    If BOE anticipates inflation falling below government’s target of 2% and economic growth is slow they are likely to cut interest rates.

  • This should in theory stimulate economic activity

  • This is because of reduced borrowing costs

  • This increases disposable income of consumers with mortgages.


    • Tight Monetary Policy


    If BOE feels the economy is growing too quickly and inflation is expected to exceed the government’s target, they are likely to increase interest rates to slow growth and inflationary pressure.


    Instruments of Monetary Policy

    There are two types of monetary policy instruments:

    Those that affect money supply

  • Quantitative easing
  • Reserve asset ratios


    • Those that affect the publics demand for money

  • Interest rate
    • Advantages of Interest Rates
    1) Highly Effective

    Cut in interest rate may increase 3 of 4 components of aggregate demand. Consumption, investment and net exports:

  • Lower Interest rates raise consumption due to lower returns on saving and ‘wealth effect’ (switching from banks to shares)

  • Increase consumption is likely to stimulate investment, as producers will expect to sell higher output

  • Lower interest rate will reduce demand for currency leading to fall of value of currency thus increasing exports and reducing imports


    • 2) Supply-side Effects

    When interest rates fall, investment increases which will have a supply-side effect in the economy as the quantity and quality of capital goods increases.


    3) Quick Implementation

    Interest rates can be altered on a monthly basis, or more frequently as seen in the U.S and Russia.

    However interest rate changes have a time lag of 1 to 2 years due to consumers being fixed to loans and mortgages. Due to these time lags, the effect of interest rate changes can be offset by changes elsewhere in the economy e.g. if recession is expected.

    Also frequent changes in interest rates reduce confidence and will have less of an effect each time.


    4) Flexibility

    Interest rates are highly flexible and can easily be adapted to changes in the economy. The MPC is able to change interest rate by the decimal, unlike government fiscal policy measures, which require values that are easy for people to understand.


    5) Lack of Political Influence

    Since interest rates are set independently by the MPC, the value of interest rate is free from political influence giving it more credibility and accountability.

    Fiscal policy measures are set by the government and it could be argued that they are used in the interest of the political majority rather than in the interest of the economy.
    Disadvantages of Interest Rates
    1) Risk of Inflationary Pressure

    Households may respond to lower rates of interest by increasing spending. But firms may be reluctant or unable to increase output, due to factor immobility. Firms therefore increase prices.

    2) Debt

    Cutting interest rates may encourage households to take on too much debt or firms to over expand:

  • 2008 housing market – Households believed house prices would rise and interest rates would remain low. As a result they began to aquire high rates of credit which they were ultimately unable to pay back

  • In 1980’s and early 1990’s Japanese banks lent to risky enterprises, which went bankrupt and were unable to repay loans

    • 3) Time Lags

    Economists believe that it takes 18 months for a change in interest rates to fully feed through into the economy. This is because of the size of the transmission mechanism and the amount of time it take for interest rates to feed through different channels of the economy.

    4) Interest rates can't fall below 0%

    Interest rates have a limit to their use. Once an interest rate is reduced to 0% it can't fall any lower. This has led to huge problem in countries such as Japan where interest rates have become ineffective at stimulating the economy.
    Evaluation
    Effectiveness of interest rates depends on the level of confidence in the economy. When there is little confidence, interest rates have no effect because no one wants to borrow. This was the case in the 2008 recession.

  • Financial institutions do not always follow Central Bank interest rates

  • Independence of MPC from government prevents political interference

    • This independence and accountability may help to create policy credibility, anchoring inflationary expectations. This independence and accountability may help to create policy credibility, anchoring inflationary expectations.

    The effect of interest rates may also be offset by other factors e.g a contractionary fiscal policy may offset the effect of a fall in interest rates.









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