Monetary policy is the manipulation of monetary variables (interest rate and money supply) by the MPC to influence AD and inflation.
An economy’s central bank controls the interest rate and money supply. In the UK the central bank is the Bank of England (BoE). However, it is not the BoE who decide on interest rate changes, instead this is decided by the Monetary Policy Committee (MPC). The MPC is a group of 9 economists, 5 are from the BoE and 4 are independent experts and they are responsible for controlling inflation in the UK. The MPC use the CPI measure of inflation and target inflation of 2% plus or minus 1%. The MPC use the interest rate and money supply to influence AD and control inflation. The MPC are independent from the government and apolitical so they have credibility in inflation targeting.
The MPC meet once a month and consider all the factors affecting inflation over the next 2 years: – Economic growth. Higher growth causes income and consumption to rise and demand-pull inflation. – Consumption. An increase in consumption causes demand-pull inflation. – Asset prices. A rise in house prices induces a wealth effect that increases consumption and causes demand-pull inflation. – Unemployment. Lower unemployment means income and consumption rise so there is demand-pull inflation. – Exchange Rate. A fall in the exchange rate causes exports to rise, imports to fall and demand-pull inflation. Also, imports are more expensive so there is cost-push inflation. – Commodity prices. A rise in commodity prices means imported commodities are more expensive and firms’ costs rise so there is cost-push inflation. – Less Developed Country (LDC) wages. UK workers must compete with low wages in LDCs to attract MNCs and find employment, this leads to lower wages for UK firms and cost-push deflation.
After considering all the factors affecting inflation, the MPC predict inflation over the next two years and decide on what should happen to interest rates to keep inflation within its target. If inflation is too low, the MPC will use loose monetary policy to decrease interest rates and increase inflation. If inflation is too high, the MPC will use tight monetary policy to increase interest rates and decrease inflation.
Loose and Tight Monetary Policy A loose monetary policy causes interest rates to fall and AD to rise. Multiplier effects make AD rise further. The price level rises and real GDP rises.
Monetary Policy influences AD through:
A fall in interest rates means the cost of borrowing falls so consumers take out more loans and buy more credit-bought items. Furthermore, the return on savings falls so saving becomes less attractive and consumption becomes more attractive. Consumptionrises, AD rises, the price level rises and real GDP rises.
A lower interest rate means savings generates a lower return so more investment projects become profitable. Moreover, a fall in interest rates means the cost of borrowing falls, investment becomes cheaper so firms take out more loans and invest more. Investment rises, AD rises, the price level rises and real GDP rises.
3) Exchange Rate.
A fall in the domestic country’s interest rate means the return on domestic saving falls relative to the rest of the world so domestic and foreign consumers will save less in the domestic economy and save more overseas. Demand for the domestic currency falls, the domestic currency’s exchange rate falls, the domestic economy becomes more internationally price competitive, exports become cheaper and rise, imports become dearer and fall, the current account moves towards a surplus, AD rises, the price level rises and real GDP rises.
4) Housing Market.
A fall in interest rates lowers mortgage repayments, consumers’ debt falls, disposable income rises so consumption rises. Moreover, lower interest rates means mortgages are cheaper so demand for houses rise and house prices rise. As house prices rise, homeowners’ wealth rises inducing a wealth effect. A homeowner can borrow more against the higher value of their home and increase consumption (equity withdrawal). Consumption rises, AD rises, the price level rises and real GDP rises.
The Effectiveness of Monetary Policy Monetary policy’s effectiveness depends on many factors:
1) Magnitude of Interest Rate Change.
Monetary policy’s effectiveness depends on the magnitude of the change in interest rates. Monetary policy is more (less) effective the larger (smaller) the change in interest rates. A larger (smaller) fall in interest rates means AD rises a lot (a little), the price level rises a lot (a little) and real GDP rises a lot (a little). Moreover, the shift in AD depends upon the size of the multiplier. Monetary policy is more effective the larger (smaller) the multiplier.2) Elasticity of LRAS.
Monetary policy’s effectiveness depends on the elasticity of the LRAS curve. Monetary policy is more (less) effective in raising real GDP the more elastic (inelastic) is LRAS. Conversely, monetary policy is more (less) effective in raising inflation the more inelastic (elastic) is LRAS.
If LRAS is elastic there is a lot of spare capacity, a loose monetary policy boosts AD, real GDP rises a lot but the price level rises a little bit (maybe stays the same).
3) Short-Run vs. Long-Run.
A lower interest rate increases investment so AD shifts right, the price level rises and real GDP rises in the short-run. More investment means new and more efficient technology is developed so the economy eventually becomes more productive, LRAS shifts right, real GDP rises and the price level falls in the long-run. 4) Interest Elasticity of Investment.
An interest rate drop will not affect investment if investment is interest inelastic because investment does not respond to interest rates. An interest rate drop affects investment if investment is interest elastic because investment responds to interest rates.
5) Time Lags.
Monetary policy takes time to come into effect due to time lags. An interest rate change takes roughly 2 years to exert its full effect. Moreover, the multiplier takes roughly 2 years to exert its full effect.
6) Liquidity Trap.
A liquidity trap occurs when the interest rate is at its minimum, interest rates cannot fall any lower. Monetary policy becomes ineffective, interest rates cannot fall any lower so monetary policy cannot be used to increase real GDP and the price level.
Quantitative Easing Another instrument the MPC can use to target inflation is quantitative easing.
Basically quantitative easing is the control of the money supply to influence AD and inflation. If inflation is too low, the central bank could pump money into the economy by buying assets (usually government bonds) from agents.2 Banks like Barclays sell their government bonds to the central
bank, so Barclays has more money to lend, consumers can take out more loans so consumption rises, firms can take out more loans so investment rises and AD rises. Multiplier effects make AD shift further and inflation increases.
However, quantitative easing is relatively untried in the UK, it was first used in 2009, so its effects may be unpredictable. Maybe quantitative easing is dangerous, it could make inflation rise above target and become out of control.
Problems Facing the MPC The MPC face many problems when setting interest rates to target inflation:
Higher interest rates reduce inflation but they may also reduce AD, income, employment and real GDP. This causes a conflict with the government’s macroeconomic objectives.
It takes time to change interest rates. Also, it takes roughly two years for interest rates to exert their full effect on investment and consumption. This makes it more difficult to plan what should happen to interest rates.
Some events cannot be predicted (maybe oil price shocks or financial crises). Resultantly, the MPC will fail to implement an effective policy response, interest rates may be too high or too low so inflation will be off target. Maybe new economic models need to be built to explain these shocks.
4) Data Reliability.
Data may be imperfect, and if the MPC plan and act with inaccurate information they will set the wrong type of interest rate response.
5) Conflicting Data.
Conflicting data makes it more difficult for the MPC to decide on the interest rate response. Some data could indicate that inflation is rising so interest rates must rise whilst other data indicates that inflation is falling so interest rates must fall.
Economists do not agree on the ‘correct’ model of the economy (for example Keynesian models vs. Classical models). MPC members may not agree on models, some may argue that interest rates must rise whilst others may argue that interest rates must fall.