Monetary Policy

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Meaning of monetary policy

  • Any deliberate action undertaken by the government or its agents, such as the country's central bank, to achieve economic objectives by using monetary instruments such as controls over bank lending and the rate of interest.
  • Exchange rates and Interest rates

The role of the Bank of England in implementing monetary policy

  • The bank of England was made independent and it is now the sole monetary authority, with a duty to achieve the monetary policy target set by the Treasury
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The Instruments of monetary policy

Interest rates - that the Bank of England, Monetary Policy Committee sets each month

The Banks interest rate or lending rate is also called Bank rate

A change in the Bank of England's interest rate quickly affects other short-term interest rates (such as the overdraft rates that banks charge to personal and business customers) and usually affects mortgage interest rates at which homeowners borrow over the long term

Exchange rates

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The objectives of monetary policy

  • By raising or lowring Bank rate, The B of E hopes to influence the interest rates set by commercial banks, and thereby to manage the level of AD.
  • This is done to try and achieve the policy objective set by the government, which is control of inflation
  • However critics argue that the policy has a built-in deflationary bias
  • This is no longer the case, because the MPC is prepared to reduce interest rates to stimulate output and employment if it believes that on unchanged policies, an inflation rate below 2.0% will be accompanied by an undesireable fall in output and employment

The primary objective of monetary policy is price stability, but subject to that, the Bank of England must also support the government's economic policy objectives, including those for growth and employment

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Using AD/ AS diagrams to show how it affects price

AD = C + I + G + E  - M

diagram to show how raising interest rates decreases AD

Encouraging people to save, less income is therefore available for consumption. Higher interest rates also cause buisnesses to postpone or canel investment because they believe higher borrowing costs make the purchase of capital goods unprofitable

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Linking monetary policy to the exchange rate and t

  • The third way in which an increase in interest rates leads to a decrease in AD works through the effect of higher interest rates on net export demand (E-M)
  • A higher interest rate attracts capital flows

  • This causes the pound's exchange rate to rise, which makes UK exports less price competitive on world markets and imports more competitive in UK markets
  • The balance of payments on current account worsens, shifting the AD curve to the left

  • A cut in interest rates has the opposite effect
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