Monetary policy is the use of interest rates, money supply and exchange rates to influence economic growth and inflation
Interest rates – are the cost of borrowing money
Exchange rates – the value of one currency in terms of another
Money supply – the amount of money in circulation in an economy
Monetary Policy and The Bank Of England
The monetary policy committee at the Bank of England are able to influence the money supply and set interest rates. The Bank of England do not control money supply from the supply side instead they control interest rates as they believe these will control the demand for money in the economy
The committee take a gradualist approach to monetary policy – they believe that by moving interest rates in small steps they can achieve their aims and not create consumer hysteria at the rises
The Bank sets the rate of interest after analysing macroeconomic trends and risks associated with inflation. The Bank of England is independent from government control. Since 1997 the UK government has used interest rates to control the level of inflation in the economy (at a level of 1.5-3.5% - target = 2.5%)
If the Bank believes the level of Aggregate Demand is rising too quickly potentially causing cost push inflation they will decide to raise interest rates
Considerations when Setting Interest Rates
The Bank looks at the following factors:
- Economic growth and capacity utilisation
- Unemployment
- Consumer borrowing
- Inflation
- Consumer and business confidence
- Trends in exchange rates
- International economic data
- Future predictions
Transmission Mechanism
When the Bank Of England changes interest rates it takes time for the effects to be transmitted to the economy
The new interest rate is transmitted to consumers through market interest rates which influence the cost of credit and borrowing, price of assets, expectations and exchange rates
These in turn transmit the information through their influence on aggregate demand which can lead to an inflationary / deflationary response
Interest Rates and the Economy
Changes to interest rates influence many things in the economy:
- Housing prices and housing market – if interest rates rise the cost of mortgages increases therefore reducing demand for housing in theory (this has not occurred recently in the UK)
- Disposable income of house owners – if interest rates rise the real disposable income of home owners falls as they have larger mortgage payments (variable rate only)
- Investment – if interest rates rise they lead to a decrease in the level of investment
- Exchange rates – An increase in interest rates may lead to an appreciation of UK currency making exports less attractive
Interest Rates & Credit Demand
Credit demand – if interest rates rise the amount of credit sales should decrease as it becomes more expensive
- If credit is more expensive consumers monthly payments will increase on existing debts which means they have less disposable income
- If credit is cheaper than more people will apply for it and use it
Objectives of Monetary Policy
Monetary policy is used to achieve the governments economic objective. The main objective of monetary policy is stable prices or the control of inflation.
The UK government have been able to achieve inflation within the target zone by allowing the bank of England to set interest rates
The Exchange Rate
The Exchange Rate is a Target and Instrument of Economic Policy. Exchange rates show the price of one currency in terms of another.
Changes to the exchange rate can influence the policy objectives of inflation, unemployment and the balance of payments
Exchange Rates and Inflation
Exchange rates influence inflation because:
- It impacts the price of imports
- It impacts the price of exports
- It changes the price of oil and other commodities – oil is sold in $ so when the exchange rate of £ to $ changes so does the price of oil
- It can influence wage bargaining power
Exchange Rates and Unemployment
If exchange rates appreciate economic growth tends to be slower which reduces AD and therefore unemployment can occur
Exchange Rates and the Balance of Payments
Exchange rates change the relative values of imports and exports. If the value of the £ is higher it means imports are relatively cheap and therefore the demand for them increases.
A high value £ also means that exports will be more expensive so demand for them decreases. This can cause a balance of payments deficit.
If the value of the £ is lower then it means imports are more expensive and exports are cheaper therefore it can result in a balance of payments surplus
Interest and Exchange Rates
Changes in the UK’s interest rates will lead to changes in the exchange value of the pound
If interest rates rise the value of the pound will rise so the pound will now buy more US dollars, Japanese Yen, Euros etc.
If interest rates fall the value of the pound will fall so the pound will now buy less US dollars, Japanese Yen, Euros etc
Floating Exchange Rate
There are a number of different methods of exchange rate systems:
- Free floating exchange rates – here the value of the currency is determined by its supply and demand
- Managed floating exchange rates – There may be some government / central bank intervention if there are large movements or its deemed beneficial for economic policy
Fixed Exchange Rate
- Semi-fixed exchange rates – currency movements are allowed within set boundaries, interest rates are used to control exchange rates
- Fully fixed exchange rates – The exchange rate is pegged at a certain point
Exchange Rate Control
Some countries use exchange rate control as a way of influencing their economy
If exchange rates are fixed competitiveness can be increased as they are able to reduce costs in the knowledge that their exchange rate will stay constant
UK Exchange Rate
The UK has a free floating exchange rate so the price of the £ is influenced by the interaction of supply and demand
The UK has had a free floating exchange rate since 1992
