Monetary Policy A demand-side policy – shifts AD (secondarily affects AS) 1. Changes in short-term interest rates to influence the level of AD & inflation 2. Quantitative Easing (QE)

Economic Effects of Interest Rate Changes Exchange Rate Housing Market Credit Demand Interest rate changes will impact: Investment Saving

Monetary Policy Committee MPC has 9 members Governor plus 4 from the Bank of England (including 2 Deputy Governors) 4 external members appointed by the Chancellor The MPC set interest rates every month in order to meet their mandate from the chancellor of the exchequer: “inflation must be at 2%” (if inflation is below 1% or above 3%, the MPC must explain why in an open letter to the Chancellor) Economic data is considered to assess the potential of each indicator to impact inflation

What do the MPC look at when deciding if inflation might become too high / too low… Exchange Rate Rate of GDP Growth Wage Inflation Housing Market Credit Demand Economic data for consideration Unemployment Manufacturing Output Investment Retail Sales MPC must consider all these things in the economy to assess the inflationary pressure that is likely – decide whether they need to change interest rates to achieve 2% inflation target.

How it will affect inflationary expectations… Investment Economic indicator How it will affect inflationary expectations… Investment If it is rising, then this will increase AD in the short run, causing Demand-Pull inflation. (In the longer term, it might lower production costs through greater efficiency reducing inflation again if AS shifts out) If it is falling then… Unemployment If it is rising, then… Housing Market Rate of GDP Growth If it is high, then… If it is low then… Exchange Rate Wage Inflation Credit Demand Manufacturing Output Retail Sales

Advantages of Lower Interest Rates Cheaper for businesses to finance capital investment - long-run economic growth Households enjoy cheaper loans for homes, cars, etc – boost to C Easier to start new businesses – source of long-run growth Reduced interest burden on the national debt for the Government - reallocate spending Currency may fall

Disadvantages of Lower Interest Rates Disincentive to save – (savings needed to finance investment, education, etc) Retirees may see incomes fall Credit boom may fuel rising inflation Currency may fall

Quantitative Easing Used when interest rates are already low and AD still needs stimulating Bank of England creates new money electronically B of E buys bonds from financial institutions (eg. pension funds, commercial banks) Commercial banks have more cash to lend out to customers ↑ money available for lending → ↓ interest rates → ↑C & I → ↑AD

Criticisms of Monetary Policy Difficult to assess state of the economy based on monthly data Time lags – takes up to two years for effects to be fully realised in the economy Effects on currency may be undesirable One size fits all – needs of one sector may be opposite to those of another – can’t be targeted at problem areas May not be effective if already anticipated