Monetary Policy in the UK

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AS Economics
Monetary Policy
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The Bank
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The Bank of England
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What is monetary policy?
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Your task
Question Definition
Inflation is A The manipulation of interest rates and the money supply in order to manipulate the level of aggregate demand.
Monetary policy is B The cost of borrowing money.
The interest rate is C A sustained rise in the general price level.
The Consumer Price Index is D A sustained fall in the general price level.
Deflation is E The average household cost of living excluding housing costs.
Demand-side policies are F Monetary and fiscal policies designed to manipulate the level of aggregate demand.
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Answers
Question Answer
Inflation is A sustained rise in the general price level.
Monetary policy is The manipulation of interest rates and the money supply in order to manipulate the level of aggregate demand.
The interest rate is The cost of borrowing money.
The Consumer Price Index is The average household cost of living excluding housing costs.
Deflation is A sustained fall in the general price level.
Demand-side policies are Monetary and fiscal policies designed to manipulate the level of aggregate demand.
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Key Issues

• To understand monetary policy issues.
• To understand how monetary policy is used to
  control inflation.
• To appreciate the main effects of changes in
  interest rates.
• To know recent trends in UK interest rates
• To be aware of the level of independence for the
  Bank of England

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The aim of monetary policy
The main aim of monetary policy is to help keep
macroeconomic stability in the economy and also
to maintain the value of money i.e. achieve
price stability
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The instruments of monetary policy

• Monetary policy involves the use of interest
  rates and other instruments of policy to control
• The growth of AD (CIGX-M) relative to the
  economys productive potential
• The demand for and supply of money and credit
• To occasionally influence the value of the
  exchange rate

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mortgages
savers
Credit Card holders
In debt
spenders
Pensioners
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What is Monetary Policy?

• Since 1997 monetary policy has been in the hands
  of the Bank of England
• Currently monetary policy concerns changes in
  short term base interest rates
• The main objective of monetary policy is price
  stability
• Monetary policy seeks to influences AD it has
  little direct impact on LRAS
• The Government sets the inflation target

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Monetary Policy Committee

• Main objective for the Bank of England
• Meet the inflation target Inflation of 2.0
• Monetary policy is designed to be pre-emptive
  (forward-looking) i.e. raise interest rates
  before inflation accelerates, or cut interest
  rates to avoid an inflation under-shoot /
  economic recession
• Changes in official interest rates filter their
  way through the rest of the UK financial system
  (e.g. savings rates and mortgage rates.

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Reading the macroeconomic tea-leaves

• When making decisions on whether or not to change
  interest rates, the monetary policy committee
  will consider many economic factors
• Economic conditions in the UK economy
• Trends and fluctuations in the European and
  global economy
• This involves a detailed look at what is
  happening and what it might mean for inflation

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Members.

• 9 members
• Governor
• 2 Deputies
• 2 Bank executive directors
• 4 govt appointed members

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Setting Rates The Economic Assessment

• Demand-side factors
• Real GDP growth
• Estimate of the output gap
• Consumer spending
• Net Exports (Trade)
• Government spending
• House Prices
• Unemployment
• Consumer borrowing
• Business Consumer Confidence

• Supply-side factors
• Wages and earnings
• Labour Shortages
• Import prices
• Commodity prices (e.g. oil)
• International Factors
• Sterling Exchange Rate
• Global Inflation Trends

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Prioritise activity

• Which 3 factors do you consider to be THE MOST
  important factors for keeping IRs low in UK?

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MPC Meetings

• The MPC considers the macro-economic background
• They assess a broad range of economic indicators
• Is aggregate demand too strong?
• Are there inflation signals from the labour
  market?
• Is there a risk of inflation from import prices?
• How will exchange rate changes affect costs and
  prices

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An Inflationary Gap
LRAS
Price level
Above full-employment equilibrium
SRAS
AD
Real National Output
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Base Interest Rates The Long Run Picture
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• IRs effecting mortgage holders

• IRs winners and losers

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(No Transcript)
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The effects of interest rate changes
Changes in interest rates affect virtually every
part of the economy from homeowners with a
mortgage, to business confidence, to the exchange
rate and the prospects of UK exporting businesses
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Transmission Mechanism. What would happen if
IRs rise?
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Transmission Mechanism if IRs rise
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(No Transcript)
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LOW interest rates Winners or Losers?

• A homeowner with a mortgage of 250,000
• A pensioner couple who have paid off their
  mortgage and have a good level of savings in a
  building society account
• A travel agent, 70 per cent of the holidays they
  sell are to British consumers to overseas
  destinations
• A manufacturer of kitchen units in the West
  Midland with a high level of bank loans
• A builder who specialises in home improvements.

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How Monetary Policy affects AD
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Channels of Monetary Policy
INTEREST RATE CHANNEL
BANK LENDING CHANNEL
EXCHANGE RATE CHANNEL
WEALTH EFFECT CHANNEL
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Interest rates and effective disposable income
Effective disposable income post tax income
after the effects of mortgage interest
repayments So a rise in interest rates will
(other things remaining the same) lead to a fall
in the effective disposable income of homeowners
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Will there ever be 0 IR?

• http//news.bbc.co.uk/1/hi/business/7791425.stm
• To what extent will 0 interest rates help an
  economy out of a recession?

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Limits to the Impact of Rate Changes

• Some factors may dampen the impact of rate
  changes
• (1) Mortgage interest rates do not always follow
  base rate change
• (2) Many home-owners are on fixed rate mortgages
• (3) People in rented property see no direct
  effects from changes
• (4) Credit-card lenders may not change rates
  immediately

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Limits to the Impact of Rate Changes

• (5) If businesses are operating with spare
  capacity, a fall in rates will not necessarily
  lead to higher planned capital investment
• (6) Many sources of funding for capital spending
  (e.g. loans and debentures) are at fixed rates of
  interest
• (7) Lower interest rates causes a fall in the
  effective disposable income of millions of people
  with net savings

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White board activity
AS Economics

• On one side write Monetary
• and on the other Fiscal

Monetary Policy
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You decide is it monetary or fiscal?

• A cut in corporation tax
• A restriction on bank lending
• A reduction in the budget deficit
• An increase in govt subsidies
• An increase in interest rates

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BoE Govt dilemma

• Why if IRs are being reduced so much is our AD
  / GDP not expanding?
• Why are consumers businesses not spending any
  more?
• Are the high street banks willing to lend at
  0.5?
• Why not?

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• How can interest rates be used to control demand
  pull inflation?
• Draw a Demand pull inflation diagram
• How can IRs influence AD?
• Can IRs influence LRAS?

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HOMEWORK
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Next lesson

• Return of BoP past paper work
• Review of Budget
• Exam revision another past paper review