Economics Department
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Economics Department |
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Monetary Policy week 2, practice and implications.
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The following text is taken from a Bank of England Fact Sheet on Monetary Policy in the UK. Read the text and answer the questions that are incorporated into the document.
Monetary Policy in the United Kingdom
The objective of monetary policy is price stability - to maintain the value of money - or, to put it another way, to restrain inflation or the general increase in the prices of goods and services. Uncertainty about inflation - and thus about future price levels - is damaging to the proper functioning of the economy. With a stable general price level, individual price signals can be read more clearly, and more rational decisions taken about whether to save or to borrow,how much to invest and to consume, and what and when to produce. In this way, price stability can help to foster sustainable long-term economic growth.
1) Explain with the aid of a diagram the link between a stable price level and long term economic growth. (5 marks) 2) Explain how inflation might interfere with the functions of the price mechanism. (5 marks)
Monetary policy operates by influencing the cost of money, i.e. the short-term rate of interest. The Bank sets an interest rate for its own dealings with the market and that rate then affects the whole pattern of rates set by the commercial banks for their savers and borrowers. This in turn will affect asset prices (e.g. shares and property), consumer and business demand and, ultimately, output and employment.
Broadly speaking, the objective is to keep aggregate demand as far as possible in line with the productive capacity of the economy. If rates are set too low this may encourage the emergence of inflationary pressures so that inflation is persistently above target. If they are set too high there is likely to be an unnecessary loss of output and employment, and inflation is likely to be persistently below target.
3) Explain with the aid of diagrams how an incorrect interest rate decision might lead to: (a) "The emergence of inflationary pressures" (5 marks) (b) "An unnecessary loss of output and employment" (5 marks)
THE POLICY FRAMEWORK
In June 1997, the Chancellor announced that he was setting the Bank a target of 2.5% for retail price inflation excluding mortgage interest payments (RPIX). Decisions on interest rates are normally made by the Monetary Policy Committee (MPC) of the Bank which was established by the 1998 Bank of England Act. The MPC meets monthly. Decisions are announced immediately after the meeting and the minutes are published two weeks.
The Governor is also obliged to write an open letter to the Chancellor if inflation deviates more than 1% on either side of the 2.5% target. Under certain circumstances, the Bank of England Act allows the Treasury to give instructions to the Bank in the field of monetary policy for a limited period of time. These powers can only be used if the Treasury is satisfied that they are required in the public interest and only by ‘extreme economic circumstances’.
4) Explain why is it considered important for the MPC to meet monthly rather than less often. (3 marks)
5) How important do you think it is that "The Governor is also obliged to write an open letter to the Chancellor if inflation deviates more than 1% on either side of the 2.5% target." (3 marks) M A R C H 1 9 9 9 Operations in the domestic money market
The main instrument of monetary policy is the short-term interest rate. Central banks have a variety of techniques for influencing interest rates but they are all designed, in one way or another, to affect the cost of money to the banking system. In general this is done by keeping the banking system short of money and then lending the banks the money they need at an interest rate which the central bank decides. In this country such influence is exercised through the Bank of England’s daily operations in the money markets.
6) Explain how the Bank of England can keep the banking system short of the money that it needs through daily operations in the money markets. (5 marks)
THE EFFECTS OF INTEREST RATES A change in interest rates will affect the economy through a number of routes.
First, a change in the cost of borrowing will affect spending decisions. Interest rates affect the relative attraction of spending today as against spending later, as a rise in rates will make savings more attractive and borrowing less so, and this will tend to reduce present spending, both on consumption and on investment.
Second, a change in rates affects the cash flow of borrowers and creditors. A rise or fall in interest rates affects the cash flow of those with floating interest rate assets or liabilities. For example, many households have floating interest rate deposits in banks and building societies. Floating interest rate debtors include households with mortgages, and companies. Fluctuations in cash flow may affect spending.
Third, a change in interest rates affects the value of certain assets, notably housing and stocks and shares. Such a change in wealth may influence people’s willingness to spend.
Fourth, a particular pressure on prices comes through the exchange rate. For example, a rise in domestic interest rates relative to those overseas will tend to result in a net inflow of capital and an appreciation of the exchange rate. A rising pound will reduce prices for imports, thus increasing competitive pressures and supplementing the downward pressure on inflation arising from weakened demand.
All of these influences on demand are likely to affect prices and inflation. A rise in short-term interest rates can be expected to restrain demand for UK output in the way described. That in turn is likely to put downward pressure on UK prices and the rate of inflation.
7) Explain using diagrams how each of the effects identified will impact on AS and AD, and consequently on inflation and unemployment. (9 marks) (40 marks) |