AS Economics Monetary Policy

The Bank

The Bank of England

What is monetary policy?

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.

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.

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

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 BoE – March 2009 – IR at 0.5%

The instruments of monetary policy Monetary policy involves the use of interest rates and other instruments of policy to control The growth of AD (C+I+G+X-M) relative to the economy’s productive potential The demand for and supply of money and credit To occasionally influence the value of the exchange rate Since 1997, the BoE has had operational independence in the setting of interest rates. The Bank aims to meet the Government's inflation target - currently 2.0 per cent for the consumer price index- by setting short-term interest rates. Interest rate decisions are taken by the Monetary Policy Committee (MPC) at their monthly meetings. New ‘in’ term … Quantitative easing!

mortgages savers Credit Card holders In debt spenders Pensioners How does a fall in Interest rates effect different sectors of the economy? savers Credit Card holders In debt spenders Pensioners

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 The Bank of England is charged with the task of 'maintaining the integrity and value of the currency'. The Bank pursues this objective through the use of monetary policy. Above all, this involves maintaining price stability, as defined by the inflation target set by the Government, as a precondition for achieving a wider goal of sustainable economic growth and high employment.

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.

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 the MPC announce changes in IR on the first Thursday of every month at 12 noon! A 2 day meeting! Wed – review of latest ec data.

Members…. 9 members Governor 2 Deputies 2 Bank executive directors 4 govt appointed members

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 EXAM SKILLS > they will be expected to prioritise….select some factors… It is important to note that monetary policy in Britain is designed to be pro-active and forward-looking. This means that the MPC is aware that changes in interest rates take time to work through the economic system. Making decisions on interest rates on the basis of today’s inflation data simply does not make sense. The Economists at the Bank must make regular forecasts of inflation and consider whether the current level of interest rates is appropriate in order to meet the inflation target. The reaction of consumers and businesses to interest rate movements is uncertain, as are the time lags arising from a change in interest rates. So the Bank of England undertakes a rigorous assessment of conditions in the economy, together with forecasts from its own economic model to find an appropriate rate of interest for the economy as a whole. Vital theory!

Prioritise activity Which 3 factors do you consider to be THE MOST important factors for keeping IR’s low in UK?

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 S.P.I.C.E.D.

An Inflationary Gap What type of inflation is this? LRAS Price level Above full-employment equilibrium Inflationary Gap SRAS How could the BoE use IR’s to manage this? How could the Govt use fiscal policies to manage this? AD If aggregate demand means that real GDP exceeds trend output, there is a risk of demand pull inflation …. The MPC may decide to raise interest rates to choke off some of the excess demand Real National Output

Base Interest Rates – The Long Run Picture There is no unique rate of interest in the economy. For example we distinguish between savings rates and borrowing rates. However interest rates tend to move in the same direction. For example if the Bank of England cuts the base rate of interest then we expect to see lower mortgage rates and lower rates on savings accounts with Banks and Building Societies Still at 0.5%

IR’s effecting mortgage holders IR’s winners and losers

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

Transmission Mechanism…. What would happen if IR’s rise?

Transmission Mechanism if IR’s rise

One side WINNERS Other side Losers… Alternative – W or L on forehead ….!

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.

How Monetary Policy affects AD Mapping out the transmission mechanism – the effects of changes in interest rates Market interest rates E.g. savings rates & credit cards Domestic Demand I.e. C + I + G Aggregate Demand AD Drives short-term economic growth Asset prices E.g. house prices Domestic Inflationary Pressure i.e. changes in the output gap (actual GDP relative to potential GDP) Official Interest Rate Set by the MPC Net External Demand i.e. X - M Expectations and Confidence Businesses & consumers Import Prices Consumer Price Inflation Exchange rate

Channels of Monetary Policy INTEREST RATE CHANNEL Expansionary Monetary Policy Lower Interest Rates Stimulate Investment Spending Increase in Economic Activity BANK LENDING CHANNEL Expansionary Monetary Policy Increase in Bank Loans Stimulate Consumer Spending Increase in Economic Activity EXCHANGE RATE CHANNEL Expansionary Monetary Policy Exchange Rate Depreciation Stimulate Exports Increase in Economic Activity How does an interest rate rise affect household sector consumption and savings decisions? (i) It reduces the “effective” disposable incomes of mortgage payers hence reduces consumer spending (ii) It raises borrowing costs discouraging C and encouraging an increase in the saving ratio (iii) It reduces demand for houses. A slowdown in the housing market reduces consumer wealth and confidence resulting in lower consumer demand WEALTH EFFECT CHANNEL Expansionary Monetary Policy Rise in Equity Prices Rise in Land and House Prices Rise in Value of Financial Wealth Increase in Economic Activity

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

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? Note: 2008 news article

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 The reaction of consumers and businesses to interest rate movements is uncertain, as are the time lags arising from a change in interest rates. So the Bank of England undertakes a rigorous assessment of conditions in the economy, together with forecasts from its own economic model to find an appropriate rate of interest for the economy as a whole. Evaluation issues

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

On one side write Monetary AS Economics White board activity On one side write Monetary and on the other Fiscal Monetary Policy

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 Now decide will each of these policies REFLATE / EXPAND or DEFLATE / CONTRACT the economy? Ask students to raise board above head for reflate or lower board to desk level for deflate….

BoE & Govt dilemma Why if IR’s 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?

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

HOMEWORK

Next lesson Return of BoP past paper work Review of Budget Exam revision – another past paper review