Economics: (3.6) Monetary Policy

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What is monetary policy

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Is a policy that aims to control the total supply of money in the economy using interest rates and other measures to influence the levels of total demand in the economy.

The Monetary Policy Committee (MPC) of the Bank of England do this.

The main objective is a low and stable rate of inflation and the government sets a specific target for the rate of inflation. The government also asks the MPC to consider other economic variables such as growth and unemployment.

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How does monetary policy work to achieve economic objectives?

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Works to achieve: economic growth, low unemployment, price stability, a balance in the balance of payments.

The Bank of England studies trends in economy to make decisions on interest rates and publish minutes for everyone to see. If MPC aims to increase the rate of economic growth and reduce unemployment that if can reduce the bank rate of interest, causing all rates of interest in the economy to fall. Extra spending leads to firms producing more, more workers being hired to meet demand etc.

MPCs main objective in monetary policy is price stability. If BofE expects fall in inflation rate, MPC cuts ingrats rates.

Other main measure BofE also use in monetary policy is quarantine easing. This is when the central bank makes more money available for financial institutions lend to households and firms, which produce more output to meet extra demand.

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Analysing how monetary policy affects the growth, employment and price stability: growth and employment

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If the BofE aims to achieve more employment and more economic growth then it can reduce the bank rate of interest, causing all interest rates to fall. This leads to an increase in spending. Here’s why:

BORROWING BY CONSUMER RISES: lower interest rates make borrowing cheaper, which encourages consumers to take out loans to finance greater spending.

BORROWING BY FIRMS RISES: cost of borrowing is cheaper for firms, which encourages firms or take out loans to finance greater investment expenditure.

SAVING FALLS: there is a smaller reward for saving, so consumers aspens rather than save.

ASSER PRICES RISE: becomes more attractive to but assets such as housing. Causes a rise in house prices so a rise in wealth for owners. Increased wealth also encourages consumers spending as confidence will be higher.

DISPOSABLE INCOMES RUSE FOR HOUSEHOLDS WITH MORTGAGES: monthly cost of mortgage repayments will fall. As the rate of interest in their monthly payments fall, it will leave householders with more disposable incomes and so should cause a rise in consumer spending.

THE EXTERNAL VALUE OF THE CURRENCY FALLS: if the UK reduces interest rates, it makes it relatively less attractive to save money in pounds in the UK, leading to less demand for the pound, causing a call in its value. Depreciation in the exchange rate makes Uk exports cheaper and so more competitive, and export sales will rise. Meanwhile, imports become more expensive and home-produced goods will be purchased instead. Helps to increase total demand in the economy.

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Analysing how monetary policy affects the growth, employment and price stability: price stability

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If the BofE anticipates inflation increasing above target (2%), the MPC is likely to increase interest rate, as it should reduce total demand. Here’s why spending decrease when interest rates rise:

BORROWING BY CONSUMERS FALLS: cost of borrowing rises so consumers don’t fake out loans to finance spending.

BORROWING BY FIRMS FALLS: cost of borrowing rises, which discourages firms from taking out kind to finance greater investment expenditure. Even if firms use their own money, the opportunity cost is greater as is not gaining interest from money in bank.

SAVING RISES: greater rewards from interest for saving.

ASSET PRICES FALL: become less attractive to but assets, which causes house prices to decrease and fall in wealth. Reduces wealth discourages consumer spending, confidence will be lower.

DISPOSABLE INCOME FOR HOUSEHOLDS WITH MORTGAGES: monthly cost of mortgages repayment rises. Leaves householders with less disposable income and so causes fall in consumer spending.

EXTERNAL VALUE OF THE CURRENCY RISES: a rise in interest rates tends to raise the external value of the currency. This makes imports cheaper and helps to reduce inflation.

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Evaluating the effects of monetary policy on consumer spending, borrowing, saving and investment: consumer spending

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Extent to which consumer spending rises as interest rates fall is not know in advance. Depends as some may deliberately reduce their savings and consume more. Households with mortgages are more affected when interest rates fall; large impact on consumer spending, as are going to be spending less each month in mortgage interest payments. There, they will have more to spend on other g/s. Vice versa. Some households have fixed-interest mortgages so monetary policies won’t affect them.

Some consumers, eg retired people, may rely on interest from their savings as an important path of their incomes. If interest rates rise, they have a higher disposable income and so spends more. If I treat rates fall, they have a lower disposable income and will spend less.

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Evaluating the effects of monetary policy on consumer spending, borrowing, saving and investment: Borrowing

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Lower interest rates are good for borrowers, as they can borrow more in order to spend. The amount payed back has less interest so less is paid back than in periods of higher interest rates.

May not always increase spending as depends on consumer confidence (wether they think rates will stay the same or not).

It may be the case that bank rates are reduced to encourage borrowing, but banks are unwilling to lend.

In conclusion, lower interest rates encourage borrowing, but then extent to which borrowing rises depends upon various issues.

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Evaluating the effects of monetary policy on consumer spending, borrowing, saving and investment: Saving

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The opportunity cost of spending is the interest that could be earned from saving money instead, so a rise in Interest rates means opportunity cost is higher. However, if the interest d’âges in consumers savings accounts rise by a small percentage, we don’t know how many would deliberately increase their savings and consumer less. Again there my not be much effect on saving just because the reward for saving has risen. There may be other factors affecting savings that are more important.

Some savers, eg retired, may rely on interest from their savings as an important part of their incomes. If interest rates fall, they will reduce their savings in order to maintain their level of consumer spending.

Reductions in interest rates may not have much effect in a situation where the general price level is falling. People may still prefer to save as the real interest rate is still quite high, as as they know prices will be lower in the future.

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Evaluating the effects of monetary policy on consumer spending, borrowing, saving and investment: Investment

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Investment is the purchase of capital goods by firms. 2 sources of finance for investment are retained profit and loans. Rate of interest on loans may affect firms decision to invest so if rates of interest rises they may be out off from undertaking some investment.

Also true if using own profits, as opportunity cost has risen, as not earning interest from savings.

Business confidence is important factor affecting investment decisions. If confidence is low, a cut in interest rates may not encourage more borrowing for investment.

There are a range of other factors that affect investment decision apart from changes in interest rates and business confidence. These include: the expected returns from the investment, the state of the economy as a whole, the actions of competitors, taxes on profits etc.