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
Interest Rates
The Bank of England are responsible for setting interest rates in the UK. The Bank sets the rate after analysing macroeconomic trends and risks associated with inflation.
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 AD is rising too quickly potentially causing cost push inflation they will decide to raise interest rates
Interest Rates & 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)
- Credit demand – if interest rates rise the amount of credit sales should decrease as it becomes more expensive
- 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 & Inflation
Interest rates are used to control inflation as when interest rates are increased consumption decreases as peoples real incomes are eroded by mortgage payments and credit payments and the opportunity cost of spending has increased
By controlling interest rates the government aims to keep inflation at a low level
Interest & 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
Exchange Rates
A fall in the exchange rate reduces the price of exports and increases the price of imports
Domestic demand will be stimulated and more people will buy exports as they are cheaper
This will create a deficit on the current account of the balance of payments
As consumption will increase it will increase AD which will increase the level of output in the economy and more it towards full employment
