Monetary Policy EdExcel AS Economics 2.6.2

What is Monetary Policy? Monetary policy involves changes in interest rates, the supply of money & credit and exchange rates to influence the economy Market interest rates Bank Lending Currency markets Inflation targets Bank of England European Central Bank

UK Monetary Policy – A Brief History Belief in the theory of monetarism, money supply targets Late 1980s – shadowing the German Mark to control inflation 1990-1992 UK entered the EU exchange rate mechanism in October 1990 A system of semi-fixed exchange rates – pegged to the Mark 1992-1997 Sept 1992 – Sterling devalued / UK leaves ERM on Black Wednesday Move back to floating exchange rates – government still sets rates 1997 to 2015 May 1997 - Bank of England made independent of government Monetary Policy Committee set up to set official interest rates

Interest Rates There are many different interest rates in an economy An interest rate is the reward for saving and the cost of borrowing expressed as a percentage of the money saved or borrowed There are many different interest rates in an economy 1/ Interest rates on savings in bank and other accounts 2/ Borrowing interest rates Mortgage interest rates (housing loans) Credit card interest rates and pay-day loans Interest rates on government and corporate bonds The Bank of England uses policy interest rates to help regulate the economy and meet macro objectives

Policy Interest Rates in the UK Economy The policy interest rate is set each month by the Monetary Policy Committee. The 2% inflation target is set by the government. When the Bank’s policy interest rate changes, most of the other loan and savings interest rates in the financial markets will also change too . The Bank of England has left the Base Rate in the UK unchanged at 0.5% since March 2009 – the lowest since the Bank was founded in 1694 Euro Zone interest rates are set by the European Central Bank Interest rates in the USA are set by the US Federal Reserve UK interest rates are set by the Bank of England

Examples of Interest Rates on Loans in the UK There are many different interest rates in a modern economy Bank loans Mortgages Credit card rates Payday loans Corporate bonds Government bonds Latest interest rates Base interest rate 0.5% Two year fixed rate mortgage 2% £10k unsecured loan 5%

Average Interest Rates for Types of Mortgage (2014) The chart shows the average interest rate on mortgage (home) loans in the UK in 2014. SVR = standard variable rate mortgage Source: Bank of England

Monetary Policy Interest Rates for Selected Nations 2007 2008 2010 2012 2013 2015 Brazil 12.1 12.4 9.9 8.6 8.3 13.5 United States 5.1 2.1 0.1 0.3 Australia 6.4 6.7 4.4 3.7 2.7 China 2.3 2.8 1.8 1.6 Hong Kong, China 6.6 3.4 0.5 India 7.7 8.0 5.5 8.1 7.5 7.3 Japan New Zealand 5.0 3.0 2.5 3.5 Singapore 1.3 0.4 South Korea 4.7 4.8 2.2 3.1 2.6 1.7 Eurozone 3.9 1.0 0.9 0.6 United Kingdom Source: IMF

Expansionary and Deflationary Monetary Policy Expansionary Monetary Policy Fall in nominal and real interest rates Measures to expand supply of credit Depreciation of the exchange rate Deflationary Monetary Policy Higher interest rates on loans and savings Tightening of credit supply (loans harder to get) Appreciation of the exchange rate

Negative and Real Interest Rates The real rate of interest is important to businesses and consumers when making spending and saving decisions The real rate of return on savings is the money rate of interest minus the rate of inflation. So if a saver is receiving a money rate of interest of 6% but price inflation is running at 3% per year, the real rate of return on these savings is only + 3%. Real interest rates become negative when the nominal rate of interest is less than inflation For example if inflation is 5% and nominal interest rates are 4%, the real cost of borrowing money is negative at -1%. Price deflation can lead to an increase in real interest rates

Factors Considered When Setting Policy Interest Rates The BoE sets policy interest rates consistent with the need to meet an inflation target of consumer price inflation of 2% GDP growth and spare capacity / estimates of output gap Bank lending, consumer credit figures, retail sales Equity markets (share prices) and house prices Consumer confidence and business confidence Growth of wages, average earnings, labour productivity and unit labour costs, surveys on labour shortages Unemployment and employment data, unfilled vacancies Trends in global foreign exchange markets (i.e. is sterling appreciating or depreciation against other currencies) International data – e.g. Growth rates in economies of major trading partners such as USA and Euro Area

Transmission Mechanism of Monetary Policy 1 / Change in market interest rates Normally a change in policy interest rates feeds through to borrowing/saving rates 2/ Impact on demand Effect on spending, saving, investment and exports 3/ Effect on output, jobs & investment Is there an expansion of production and employment? 4/ Real GDP and Price Inflation Rate changes then affect two of the key macro objectives It can take between 12-24 months for the full effects on real GDP and the inflation rate after a change in policy interest rates

When Interest Rates Fall A reduction in interest rates or an increase in the supply of money and credit is an expansionary or reflationary monetary policy Cost of servicing loans / debt is reduced – boosting spending power Consumer confidence should increase leading to more spending Effective disposable income rises – lower mortgage costs Business investment should be boosted e.g. Prospect of rising demand Housing market effects – more demand and higher property prices Exchange rate and exports – cheaper currency will increase exports An expansionary monetary policy is designed to boost consumer confidence and demand during a downturn / recession

Limits to the Effects of A Cut in Nominal Interest Rates Commercial banks have been reluctant / unable to lend Low Business & Consumer Confidence after the recession Falling real incomes for millions of savers High stock of personal debt holds back demand Some interest rates e.g. credit card rates have actually risen

What might happen if interest rates rise again? MPC raises interest rates Signals tighter monetary policy Market interest rates increase Cost of borrowing rises Main effect will be through via mortgages Possible slowdown in housing market And contraction in retail credit Higher rates might also cause currency appreciation Makes UK exports more expensive in overseas markets

The Keynesian Liquidity Trap A liquidity trap occurs when low interest rates and a high amount of cash balances in the economy fail to stimulate aggregate demand In normal circumstances it is possible to boost demand by cutting interest rates. But for most countries there is a zero floor for nominal interest rates Even if interest rates can be lowered this may have little effect if people cannot or will not borrow. This is known as the liquidity trap. At this point, AD can only be boosted by the Government borrowing more, either to spend directly or to give to others via tax cuts Keynesians believe that size of the fiscal multiplier effect is higher for government spending than it is for tax cuts When private sector demand for goods and services is persistently low, the government needs to find a compensating source of demand to rebalance the economy – and the solution comes from the government in the form of higher borrowing or less saving.

Interest Rates and the Distribution of Income When interest rates fall, there is a re-distribution of income away from lenders and savers towards borrowers with loans / debt Incomes of savers If the interest on savings is less than inflation, savers will see a reduction in their real incomes Incomes of home-owners with mortgages If interest rates fall, the income of home-owners who have variable-rate mortgages will increase Interest rates on unsecured debt Lower interest rates on loans such as credit cards and bank loans will fall

Quantitative Easing (QE) When policy interest rates are at zero or close to zero, there is a limit to what conventional use of monetary policy can do In March 2009 the BoE started quantitative easing for first time. The main aim of QE is to support aggregate demand and avoid the risk of a recession becoming a deflationary depression The Bank of England uses QE to increase the supply of money in the banking system and encourage banks to lend at cheaper interest rates – especially to small & medium sized businesses The Bank does not print new £10, £20 and £50 notes, it uses money created by the central bank to buy government bonds There are doubts about the effectiveness of quantitative easing – bank lending has struggled to recover since the end of the recession. In the summer of 2015, QE totalled £375bn

How Quantitative Easing (QE) is meant to work Central bank creates money electronically - Adds money to their balance sheet This money is used to buy financial assets - Mainly the purchase of government bonds More demand leads to higher prices for assets e.g. bond prices. Rise in price of bonds leads to a lower yield (%) on government bonds Can feed through to fall in long term interest rates e.g. mortgages and corporate bonds Lower interest rates and increased cash in the banking system should stimulate the economy

Main Challenges Facing the Bank of England Controlling consumer price inflation and keeping inflation expectations low Supporting a sustainable / durable economic recovery – a return to “normal conditions” Re-balancing the economy towards exports (X) and capital investment (I) Financial stability – building a more secure banking / credit system for the future

Forward Guidance when setting interest rates Forward Guidance was introduced by Mark Carney in August 2013 It has been signalled that the Bank of England will leave their policy interest rates unchanged as long as the unemployment rate is above 7.0% and inflation is under control The main aim is to build confidence by signalling that interest rates would stay at low levels for some time In 2014, Mark Carney signalled that forward guidance would evolve – LFS unemployment is not the sole data measure to be used – they will look at a range of measures of spare capacity

Has the Bank of England’s Monetary Policy helped? Case for the Bank of England Avoided a damaging depression Avoided sustained deflation + faster growth than many EU nations More competitive currency has helped export sector to recover Haven’t raised interest rates too early – responding to Euro Crisis Criticisms of the Bank’s policy Inflation allowed to rise well above target in 2008 and 2012 Signs of another unsustainable housing boom Low interest rates have become less effective e.g. in stimulating investment Britain has record current account deficit – symptom of wider structural problems

Financial Policy Committee of the BoE In addition to the Monetary Policy Committee, there is a new body at the Bank of England – the Financial Policy Committee (FPC) The FPC is charged with safeguarding financial stability The Monetary Policy Committee works through setting policy interest rates and the scale of quantitative easing (QE) The Financial Policy Committee can operate directly on the supply and price of credit in the banking system The FPC has the power to alter loan-to-value ratios (e.g. Ratio of a mortgage loan to house prices) It can also change the cash reserve requirements or capital buffers for commercial lenders – e.g. They might insist that banks keep a higher proportion of new deposits in cash rather than lend them out to businesses and households

Are low interest rates helping the UK economy? Arguments that low interest rates are helping UK macro performance Counter-arguments – the disadvantages of low interest rates Keeping interest rates at 0.5% helps maintain consumer & business confidence leading to higher C+I and thus  AD. This is important given continued slow growth in our main export markets in Europe Savers have been hit badly by negative real interest rates + income from pensions has fallen – both are bad for long term economic health. Raising interest rates will increase the disposable incomes of millions of savers If interest rates started to rise now, the £ would appreciate as hot money flowed into the UK. This could choke off demand for UK exports  negative multiplier effect and some lost jobs in manufacturing businesses Low interest rates are causing another unsustainable housing boom which in the long run is damaging for the economy. We need higher interest rates now to control mortgage debt and learn lessons from 2007 At a time when the government is pursuing fiscal austerity, it makes sense for interest rate to remain low to keep the economy growing and prevent deflation Deflation is due to external pressures e.g. oil prices. Unemployment is falling (5.5%) and wages are starting to rise (2%) so this is right moment to start raising interest rates because they take time to have an effect

Evaluation Points on Interest Rates & Monetary Policy Time lags should be considered when analyzing effects of interest rate changes Monetary policy not an exact science – consumers and businesses don’t always behave in a standard textbook way! Many factors affect costs and prices which can change the inflation risks in a country Monetary policy does not work in isolation! Consider how fiscal policy can also affect aggregate demand, output, jobs & prices Objectives of monetary policy can change – e.g. the USA Federal Reserve’s mandate is “maximum employment, stable prices, and moderate long-term interest rates”

Monetary Policy EdExcel AS Economics 2.6.2