1. Monetary Policy
EdExcel AS Economics 2.6.2

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

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

4. 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

5. 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

6. 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%

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

8. 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

9. 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

10. 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

11. 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

12. 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 months for the full effects on real GDP and the inflation rate after a change in policy interest rates

13. 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

14. 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

15. 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

16. 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.

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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”

26. Monetary Policy
EdExcel AS Economics 2.6.2