Monetary Policy

• When the government wants to influence the economy, they have 2 options:
  • Change AD
  • Improve LRAS

• There are 2 areas of policy available to governments:
  • Demand-Side Policies
  • Supply-Side Policies

• Used to achieve key macroeconomic goals - relating to growth, unemployment, inflation and the current account balance

• There are 2 different types of demand side policies:

• FISCAL POLICY: the use of taxes, government spending and government borrowing to achieve objectives

• MONETARY POLICY: the use of monetary variables, such as interest rates, quantitative easing and the money supply, to achieve their objectives
  

• To some extent, the government can control the amount of money circulating in the economy

• The government can influence the level of borrowing from banks and building societies

• Governments can do this by using the instruments of policy

• The government, through the Bank of England (the cental bank of the UK) has used two main tools:
  • Interest Rates
  • Quantitative Easing

• The government will use interest rates and quantitative easing to try and get the economy out of the prolonged recession after the 2008 financial crisis

• Rate of Interest: the price of money

• Lenders or savers expect to receive interest on any money they lend or save

• Borrowers will expect to pay interest on the funds they borrow

• Interest rates increase = Cost of borrowing increases = Return on saving increases

• Changing the rate of interest affects the economy through AD - if interest rates rise, AD will fall

• There are a number of ways interest rates will affect AD:
  • Consumer Durables
  • The Housing Market
  • Wealth Effects
  • Saving
  • Investment
  • The Exchange Rate

• Many people will buy consumer durables - such as furniture or cars on credit etc.

Rate of interest increases
=
Monthly payments increase
=
Sales of consumer durables fall
=
Consumer spending falls
=
AD falls

Interest rates increase

=

People are put off buying/moving houses

=

AD falls (for 3 reasons)

1. As demand falls, less houses are built - this would be classified as investment in AD - so investment falls. This causes AD to fall

2. If less people move house, there will be fewer purchases of consumer durables, so consumer spending falls - causing AD to fall

3. People not moving house means less people release money, which could be spent on other goods

• An increase in interest rates will decrease asset prices

Interest rates rise

=

Demand for housing falls

=

Price of houses fall; Government bonds fall in value

=

Homeowners and bond holders feel worse off so consumers spend less

=

AD falls

Higher interest rates

=

The reward to save is greater

=

Saving increases

=

Consumer spending falls

=

AD falls

Interest rates increase

=

More costly to pay back any money borrowed for investment

=

Profits can be saved rather than invested for better returns

=

Profitability falls

=

Investment falls

=

AD decreases

Interest rates increase

=

Currency appreciates

=

Imports become cheaper; Exports become dearer

=

Imports rise; Exports fall

=

Net exports fall

=

AD falls

• After the financial crisis of 2008, the UK government reduced interest rates to 0.5% - to stimulate AD
• This did not work sufficiently, so the government introduced a policy of quantitative easing
• QUANTITATIVE EASING: the process of the government buying financial assets from banks and other lending institutions

• When the government buys assets from the bank (such as bonds), they are exchanging an illiquid asset for a liquid asset
• The banks could not lend consumers a bond, so exchanging the bond for money means they can lend the money to consumers - this means they can lend more
• Consumers and firms can borrow to purchase goods and fund investment projects
• Consumer spending and investment should rise, so AD should increase

• Quantitative easing also causes the interest rate to fall due to increased demand for bonds from the government purchasing bonds, meaning the price increases on the bond - this reduces interest rates
• The fall in interest rate will have the same effects on AD - and possibly the exchange rate will depreciate

• The elected government does not directly control monetary policy in the UK
• This has been delegated to the Bank of England - so that the monetary policy is used on an independent basis
• The key decisions are made by the Monetary Policy Committee (MPC)
  • this is 9 people from the Bank of England and other independent economic experts

• At a monthly meeting, the MPC decide whether to change interest rates and whether to use quantitative easing
• Main role of the MPC is to meet the inflation target of 2% in the UK
• The Governor of the Bank of England has to write to the Chancellor if they miss the target by 1% - and explain why this has happened, and how it will bring back inflation to 2%

• The MPC also has a remit to make sure the economy is managed well - to consider growth and unemployment in its decision making
• This explains the recent period of 0.5% interest rates, as the MPC have said they will not increase rates until economic growth is stronger and the negative output gap has shrunk