Money video

The Bank of England and Monetary Policy

Government Economic Policy Monetary Policy Fiscal Policy Supply-side Policies

Aims of the Bank of England To oversee the financial system To implement monetary policy

Monetary Policy Aims to achieve the Governments macro- economic objectives using MONETARY POLICY INSTRUMENTS: Interest rates Controls over bank lending Exchange rates Money supply – recently Quantitative Easing

Prior to 1997 Monetary Policy was implemented more or less jointly by the Government and the Bank of England (B of E)– ‘the monetary authorities’ In 1997 the B of E was made operationally independent, and is now the sole monetary authority in the UK

Monetary Policy Objectives For over 30 years, the control of inflation has been the main objective of Monetary Policy in the UK – the inflation target set by the Government 2% CPI is the main policy objective Low and stable inflation helps to create the conditions in which the economy can flourish and achieve the ultimate objective of improved economic welfare for everyone

Other Monetary Policy Objectives At the present time these are not used, however: 1979 to 1985 the Thatcher Government experimented with MONETARISM and tried to control the MONEY SUPPLY in order to control inflation 1985 to 1992 the EXCHANGE RATE was used as the intermediate policy objective to control inflation, until the £ was forced out of the ERM

Monetary Policy Instruments Broadly, these are separated into those that: Affect the supply of new deposits that the commercial banks can create Influence the demand for loans or credit

Controlling the Supply of Loans and Credit Direct controls on bank lending – both a ‘qualitative’ and a ‘quantitative’ approach may be adopted These were abolished in the 80s, as the Government believed that ‘free’ market policies were more efficient than interventionist policies – more recent policies have encouraged banks to lend to stimulate business borrowing e.g. RBS directive

Using Interest Rates to Influence the Demand for Loans and Credit Modern monetary policy operates almost solely through the use of interest rate policy The B of E rations demand for credit by raising or lowering its official rate of interest, and therefore affects the level of AD in the economy via the money transmission mechanism

The Bank of England as ‘Lender of the Last Resort’ The B of E is the commercial banks’ banker At a price – the lending rate or ‘repo’ rate - it supplies cash to the commercial banks by purchasing some of their reserve assets e.g. ’bills’ and ‘gilt edged securities’ The banks then repurchase these bills later and ‘return’ their surplus cash to the B of E

The ‘Repo’ Rate The B of E’s official rate, base rate or lending rate is also called the ‘repo’ rate The word ‘repo’ is short for sale and repurchase agreement – as explained on the previous slide

Using Interest Rates to Implement Monetary Policy: An Increase in the Interest Rate This means it more expensive for commercial banks to obtain cash from the B of E The banks increase the rate of interest they charge to their own customers Loans and credit become more expensive

Using Interest Rates to Implement Monetary Policy: An Increase in the Interest Rate There is a fall in demand for loans and credit There is a reduction in total bank deposits and therefore the money supply in the economy In addition, existing loan repayments become more expensive reducing disposable income

Using Interest Rates to Implement Monetary Policy: An Increase in the Interest Rate Investment projects become less attractive There is a fall in aggregate demand This eventually reduces the inflation rate

Pre-emptive Monetary Policy Since 1992 monetary policy has been directed at a published inflation target – currently 2% CPI The B of E will increase the interest rate even when there is no immediate sign of accelerating inflation, in order to ‘pre-empt’ a rise in inflation that would otherwise occur many months ahead

Pre-emptive Monetary Policy The B of E committee members estimate what they believe the rate of inflation will be in 18 months to 2 years time If the forecast rate is different from the target rate they will change interest rates accordingly In addition, they will alter rates to pre-empt or head-off any likely adverse effects of an outside shock on the economy

Monetary Policy Since 1997 The granting of operational independence to the B of E, and the creation of the MPC within the bank to implement monetary policy Their role is to set interest rates in order to meet the Government’s published inflation target

Monetary Policy Since 1997 The MPC was made accountable for any deviations from the target rate of inflation If inflation is more than 1% point higher or lower than the target, then the Governor of the B of E has to write an ‘open letter’ to the Chancellor explaining why The letter must be published to promote transparency

Monetary Policy Since 1997: The Symmetrical Target This means that when the inflation rate is below or is predicted to fall below the target, then the MPC must stimulate aggregate demand in the economy by reducing interest rates and raising the rate of inflation Similarly, when inflation is above or is predicted to rise above the target, then the MPC must increase interest rates to reduce aggregate demand in the economy

Neutral, Contractionary and Expansionary Monetary Policy Neutral monetary policy is where interest rates neither boost nor hinder aggregate demand Where the economy is growing on or around its sustainable trend rate of growth, without negative or positive output gap

Neutral, Contractionary and Expansionary Monetary Policy Contractionary policy is consistent with a positive output gap, when actual output is above the trend rate of growth Expansionary policy is consistent with a negative output gap when output is below that required at the trend rate