Monetary Policy

Key Terms

Monetary Policy: The process by which the monetary authority of a country controls the demand and supply of money to achieve government objectives.

Base Rate: Interest rate set by the Bank of England

MPC: (Monetary Policy Committee) sets an interest rates it judges will enable the inflation target to be met.

Theory

What is monetary policy?

Monetary policy involves manipulating the supply of money in the economy using tools such as the interest rate to influence the level of aggregate demand (AD) in order to achieve macro-economic objectives.

U.K Monetary Policy Framework

At present the rate of interest stands at 0.5% at least until the Labour Force Survey headline measure of the unemployment rate has fallen to a threshold of 7%.

The MPC is also responsible for price stability which is defined by the governments inflation target of 2%. If the target is missed by more than 1 percentage point on either side – i.e. if the annual rate of CPI inflation is more than 3% or less than 1% – the Governor of the Bank must write an open letter to the Chancellor explaining the reasons why inflation has increased or fallen.

Monetary Policy Committee

The Monetary Policy Committee (MPC) is made up of nine members including the governor of the Bank of England (Mark Carney). The MPC meet for two and a half days each month to decided the official interest rate in the United Kingdom.

How does the Interest Rates Effect the Economy?

Interest rates have a direct effect on aggregate demand in the following way:

Change in interest rates primarily effect the level of saving and spending by households. For example a fall in interest rates will cause a decrease in saving and therefore an increase in spending.

This is because if interest rates fall, the amount of debt that consumers pay from borrowing falls. Therefore households are willing to spend and take on more debt as the repayment burden is smaller.Increased consumer spending in turn increases AD.

Types of Monetary Policy

Exapnsionary (Loose) Monetary Policy = ↓ Interest Rates

If BOE anticipates inflation falling below government’s target of 2% and economic growth is slow, they are likely to cut the interest rate. This is decribed in the example above.

Contractionary (Tight) Monetary Policy = ↑ Interest Rates

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.

Advantages of Monetary Policy

1) Highly effective

Interest rates are highly effective in controlling the macro-economy because all agents in the economy are in some way effected by change in policy.

2) Lack of Political Interference

The MPC is independet of the government, therefore their policy decisions are exempt from the pressures of political ambition, unlike fiscal policy.

3) Regular Adjustment

Interest Rates can be adjusted on a monthly basis by the MPC.Therefore the Bank of England can react quickly to changes in the economy.

Disadvantages of Monetary Policy

1) Confidence

Interest rates directly effect spending, therefore frequent change in interest rates require households and business to regularly monitor their spending.

Speculation of future rates of interest will reduce confidence, which will deter investment by businesses, thus limiting economic growth.

2) Time Lags

Although the interest rate can be changed on a regular basis it takes up to two years for the effects of interest rate change to materialise in the economy.