Monetary Policy

What is Monetary Policy? Monetary policy is the manipulation of the money supply, interest rates or exchange rates to influence the economy. In most other developed countries, monetary policy usually operates through influencing the price of money – the interest rate.

Interest Rate Policy Example: The Bank of England (BoE) The 'operational independence' of the Bank of England means that it can set targets for inflation and set interest rates at the level most appropriate to achieve those targets.

When the BoE changes the official interest rate it is attempting to influence the overall level of expenditure in the economy (AD). The BoE sets an interest rate at which it lends to financial institutions, known as the Base Rate.

This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers. It also tends to affect the price of financial assets, such as bonds and shares, and the exchange rate, which affect consumer and business demand.

Monetary Stance An contractionary monetary policy – seeks to restrict aggregate demand. Increasing the interest rate or restriction in the money supply. It may be used to reduce inflationary pressure or correct a balance of payments problem. An expansionary monetary policy – looks to increase aggregate demand. Reduction of interest rates or loosening of control over the money supply (Eg. Quantitative Easing) It may be used to try and increase output and employment.

The Interest Rate Transmission Mechanism The process by which a change in interest rates feeds through to AD

The Interest Rate Transmission Mechanism 1 Interest Rates Borrowing Individuals Credit Loans Consumption Firms New Loans Investment Existing Loans CostsEmploymentMargins Consumption

The Interest Rate Transmission Mechanism 2 Interest Rates Mortgages Existing New Consumption Investment Disposable Income Property Equity Demand for New Housing SavingsConsumption

Evaluating Monetary Policy T here are limitations to the effectiveness of interest rates policy.  Time lags are evident - There is an estimated time lag of months between a change in interest rates and the full effect on aggregate demand.

Evaluating Monetary Policy The central bank is restricted by policy decisions in other countries. A cut below another country’s rate may lead to a net outflow of hot money from the country, a fall in the exchange rate and inflationary pressure. Impacts on other areas of economy eg. an interest rate rise, intended to reduce inflation, may also cause a fall in output and employment.

If firms and consumers have strong views on future economic prospects any change in interest rate may be less effective. Optimistic firms and consumers may not react to an increase in interest rates by limiting their spending. They may continue to spend and invest based on their optimism. When the rate of interest is low there is little room for further cuts (and a cut at an already low rate will have less effect than when the Interest rates are cut from a higher level)