Monetary policy

What is monetary policy?

Monetary supply aims to control the supply of money in the economy and the primary tool used to do this is interest rates.

In the UK the monetary policy committee or MPC for short, who are members of the Bank of England, take quarterly decisions about interest rates. They set the base rate. This is the rate at which the Bank of England will loan money to commercial banks. Changes to this affect the rates offered by financial institutions to their customers.

The primary remit of the Bank of England is to control inflation with a target of 2%. A margin of error of 1% means in general we are happy with an inflation rate between 1% and 3% but the committee should take action to prevent inflation remaining outside this target for a long period. The Bank of England also tries to help the government meet its other targets of economic growth and low unemployment and a better balance of payments.

How monetary policy can affect growth, employment and price stability

Effect on price stability

If inflation is high the MPC will likely increase interest rates. This means firms and individuals reduce their borrowing because the cost of borrowing has gone up. This reduces demand in the economy and therefore any upward pressure on prices from demand-pull inflation.

In addition the reward for saving goes up meaning more people will save further reducing demand. However, in the UK, millions of people have mortgages or other forms of debt. A rise in interest rates will mean they have higher bills and less money to spend. This will further decrease demand.

If interest rates rise in the UK but not in other countries, then it may attract people to save in the UK. To do this they need to buy British pounds and this increase in demand for pounds cases the currency to appreciate. Because of this imports will be cheaper for individuals and firms who import inputs to their production. This helps to keep costs down and restrict cost-push inflation.

Assets like houses that rely on buyers using mortgages to fund their purchases will see a decrease in demand because of the increased costs. This can lead to a decrease in prices for houses.

Effect on growth, employment and the balance of payments

While increasing interest rates can help to combat inflation reducing interest rates can be used to stimulate growth, create jobs and improve the balance of payments.

Lower interest rates mean more individual will borrow and use this to buy stuff increasing demand. In addition the opportunity cost of investing is lower for firms.

Savers get less reward and may be more inclined to spend than save.

Those houses with mortgages have their payments reduced leaving them additional disposable income which they can use to buy more stuff increasing demand.

If our rates go down when other countries don't then foreign savers may move their money to another country. To do this they sell pounds causing a decrease in the value of the currency.

Evaluate the effects of monetary policy

When interest rates change some of the factors mentioned above are more certain than others. We know for certain the effect on people with mortgages of changing interest rates. In addition those who rely on their savings like pensioners will be heavily affected by changes in interest rates.

For savers, the size of any rate cut or rise is only one factor as some who are saving for a purpose like for a deposit for a house might not change their habits at all based on the rate. Some people are not in a position to increase savings as interest rates rise. Confidence in the economic outlook may also affect people's decisions to save.

For borrowers, the question might be consumer confidence once more. If they are certain and confident in their job and ability to pay back the loan an individual may go ahead with loans at higher rates and if they are not confident even low interest rates may not encourage them to borrow to spend. This matters equally for firms who will also consider confidence before committing to investment. There is little point to expanding if there is not going to be demand for the extra output produced. Equally if they feel they can make more money by investing than it will cost them then even high rates may not deter them from borrowing what they need.

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Questions

Explain what is meant by monetary policy. (2 marks)

A policy that aims to control the supply of money in the economy(1) with the objective of controlling inflation and helping meet the governments other objectives.(1)

Explain what the Monetary Policy Committee is. (2 marks)

A group made up by members of the Bank of England(1), that meet regularly to set interest rates.(1)

State the two economic objectives of the Government that might be helped by increasing interest rates. (2 marks)

Lower inflation(1) better balance of payments on current account.(1)

Analyse how low interest rates contribute to economic growth and low unemployment. (6 marks)

Sample answer:

Low intereest rates make it cheaper to borrow money.{AO1} This means firms would be more willing to incur debt in order to increase the size of their business.{AO2} As these businesses grow they require more workers{AO3a} and these new workers increase average incomes increasing demand for other businesses.{AO3a}

With low interest rates the opportunity cost of investing with retained profits or savngs is lower{AO2}and so firms will be more willing it spend that money to invest in growing leading to the same job growth and economic growth as a result as we saw with borrowing to expand.{AO3b}

Interest rates have risen rapidly in the UK recently from 0.25% to 2.25%. Evaluate the effects this will have on consumer spending in the UK. (6 marks)

Sample answer:

People with variable mortgages will pay more for their monthly repayments.{AO2} This will mean they have less money available to spend on other goods.{AO3a} As a large number of people in the UK have mortgages this will have a signifcant effect.{AO3b}

Higher interest rates may prompt more people to save instead of spend as the reward for saving is higher{AO3a} However, it is hard to estimate how many people may choose to save because of higher rates. Often people save for a specific purpose and many people have no extra income to save so savings levels may not change much.{AO3b}

Because a lot of UK households have mortgages these have a large effect on the level of spending but when rates rise wereas the effect of increased savings on spending will be lower.{AO3b}