Monetary policy

Monetary policy can involve controlling interest rates, the money supply and exchange rates.  In the early and mid 1970s Callaghan’s Labour Government used incomes policies as its primary weapon against inflation rather than monetary policy – this involved a “social contract” where unions would accept smaller wage increases and businesses would constrain price increases and therefore inflation would be kept under control.


The late 1970s and early 1980s saw the targeting of money supply by Thatcher’s Conservative Government.  This was replaced by exchange rate management in the late 1980s; the UK joined the Exchange Rate Mechanism (ERM) from 1990 to 1992.  From October 1992 the focus was on inflation targeting, with interest rates being used as the main economic tool.


Money Supply

The money supply is the amount of money there is in the economy.  Measuring the amount of money isn’t as simple as you may think; deciding upon the definition of money is the first difficulty to overcome.


Narrow Money (M0)

The notes and coins in circulation are referred to as narrow money or M0.  An increase in narrow money would indicate that household spending is also on the rise.  The link between narrow money and household spending not be as strong today as it was in the early 1980s due to wide spread use of credit cards and debit cards.


Broad Money (M4)

In addition to the notes and coins in circulation, broad money, or M4, also includes the money that is held in bank and building society accounts.  An increase in lending will lead to a rise in broad money.


In addition to the aggregate broad money figures (the whole economy), data is released for the different sectors of the economy – households, companies and financial institutions other than banks.


There is also information about the volume of lending by banks and building societies. Similarly, this information is available for the economy as a whole, called M4 lending, and for the individual sectors. The most important of these sectors is the lending to households.  Lending to households is split into secured and unsecured lending.  Loans secured on housing (including mortgages) represent around 80% of personal debt.


Banks will offer a lower rate of interest on a secured loan as it is less risky.  If somebody is unable to repay a secured loan the bank will be able to repossess the item the loan is secured against, for example if you are unable to keep up your repayments on a mortgage then the bank will repossess your home.  If you are unable to make repayments on an unsecured loan the bank may be left with a bad debt.


Increases in Money Supply and Inflation

An increase in the money supply could occur due to:

  • An increase in the number of notes printed will lead to an increase in narrow money.  This occurred in Germany in the 1920s, Argentina in 2002 and Zimbabwe in 2007.  This can be explained by Fisher’s Equation of Exchange: MV=PT.


  • A relaxation in the rules governing lending by banks would lead to an increase in broad money as more money is placed in the accounts of individuals and businesses.  This occurred in the UK during the 1980s.  This would lead to an increase in AD as consumers and firms were able to increase consumption and investment respectively.




The end of Money Supply targeting

In 1979 the government’s monetary policy was based upon trying to control the amount of money in the economy.  The government and economists began to realise that the growth in the money supply was not always the best predictor of demand and inflation in the UK’s economy.  Therefore by the mid-1980s, UK monetary policy was based on a much wider range of economic indicators than just the growth in money supply.


Exchange Rates

When the government started exchange rate targeting in the mid 1980s it hoped that it would lead to greater inflation stability as well as a more stable exchange rate.  If a currency weakens and the costs of imports rises an economy can suffer from imported inflations; this will be combined with a fall in the price of exports which may trigger demand pull inflation.


Business benefit from having a stable exchange rate as they have able to plan more effectively.


The UK Government followed a policy of shadowing the German Deutsche Mark (DM) as it respected the low inflation that West Germany was able to enjoy.  The government used the rate of interest as well as the buying and selling of sterling in its policy of following the Deutsche Mark.


The use of interest rates were used to either encourage or discourage hot money flows into the UK.  Fund managers are responsible for investing billions of pounds around the world; their job is to make as much money as possible by investing their portfolio where they expect to receive the highest rates of return.  The movement of this money invested by fund managers is known as hot money flows. 


After the rate of interest increases in the UK there would be an increase in the amount of hot money flowing into the UK as fund managers take advantage of the better rate of return.  This will lead to an increase in the demand for sterling which in turn will lead to an appreciation in the price of the pound.


In 1990 it took this policy one step further when the UK joined the Exchange Rate Mechanism (ERM).  The ERM required the government to follow a monetary policy that would prevent the exchange rate from fluctuating by more than 6%. The pound entered the ERM at 2.95 DM to the pound, therefore it wasn’t permitted to fall below 2.778 DM, or rise above 3.127 DM.


Many believed the pound entered the ERM at too high a value and it soon came under pressure at the bottom end of its permitted value.


The UK monetary authorities (Government and the Bank of England) tried to increase the value of the pound by increasing the rate of interest.  This had a negative impact on the economy as AD shifted to the left as a result.


The problems for the UK grew in 1992 as Germany raised interest rates to combat the inflation that followed reunification, but the UK was in desperate need of lower interest rates as it was emerging from a recession.  ERM membership forced the UK to maintain very high interest rates and central banks across Europe to buys pounds in order to prevent it falling below 2.778 DM.


Many believed that the UK wouldn’t be able to keep the pound in the ERM.  George Soros was an investor who believed that the pound had been overvalued against the Deutsche Mark when it joined the ERM and felt that the pound would soon drop out of the ERM and fall significantly in value (devaluation).  Soros borrowed around £10 billion and sold it by converting it into Deutsche Marks and French Francs.  This put so much pressure on the pound that it had to drop out of the ERM on 16th September 1992, this day became known as Black Wednesday.  After the devaluation Soros converted his Deutsche Marks and French Francs back into pounds and walked away with a profit of £550 million; he became known as “The Man Who Broke the Bank of England”.


Interest Rates

After sterling’s exit from the ERM in 1992, the government moved its policy away from targeting an exchange rate to adopting an explicit target for inflation.  Similar policies were already being used in Canada and New Zealand, but they would soon be adopted by many other countries around the world.  Interest rates were now the main tool of monetary policy in the UK and this has remained the case ever since.


The target was initially an inflation rate of between 1% and 4% using the measure RPIX.  The target for inflation was later revised to 2.5% or less.  This type of target is known as an asymmetrical target as inflation has to be below 2.5%.  If it was a symmetrical target it would be allowed to go either side of the target by a certain distance.  The CPI measure is now used and the Bank has a target of 2%.


Increasing the rate of interest

How the changes in interest rate affect the level AD is known as the transmission mechanism.


Consumption and Increasing the rate of interest

If monetary policy is to have an effect on the economy, it is important that it makes an impact upon consumers and their level of consumption as this accounts for two-thirds of AD.  There are four ways that increasing the rate of interest impacts upon the level of consumption.

  1. A consumer’s demand for loans and other forms of credit will fall following an increase in the rate of interest.
  2. The disposable income of consumers with a variable rate mortgages will fall following a rise in interest rates as mortgage repayments rise.
  3. The increase in interest rates will increase the incentive to save.
  4. Consumer confidence and the wealth effect will fall after an increase in interest rates.


All of these factors will cause the AD to shift to the left and reduce inflationary pressure.


Investment and Increasing the rate of interest

Increasing the rate of interest will affect the level of investment in the economy.  There are two ways that increasing the rate of interest impacts upon the level of consumption.

  1. The level of business confidence will fall after the rate of interest increases shifting aggregate demand to the left.
  2. The cost of borrowing and the opportunity cost (the amount the business will get from putting money in an interest bearing account) will rise; this will also cause AD to shift to the left.


Government Spending and Increasing the rate of interest

The rate of interest doesn’t have much of an effect on the level of government spending.  Even though the government will have to pay a higher rate of interest on any debt, the level of spending is determined by political factors.


Exports and Imports and Increasing the rate of interest

An increase in the rate of interest can impact upon the imports and exports and therefore the level of aggregate demand.  Following a rise in interest rates there will be an increase in hot money flows into the UK causing the value of the pound to appreciate.  This will lead to imports getting relatively more expensive and exports becoming relatively cheaper (remember SPICED).  This caused an increase in imports and a fall in exports – both shifting AD to the left.


A Decrease in the Rate of Interest

The transmission mechanism described in the previous section explains how the Bank of England can increase the rate of interest to reduce demand pull inflationary pressure.  If the Monetary Policy Committee believes that inflation will undershoot the target of 2% it could choose to reduce the rate of interest.  The effect on the economy will be the opposite to increasing the rate of interest.


It would also be possible to use monetary policy to try and inflate the economy and raise the level of national income.  This is more likely to happen during periods where there is a negative output gap.


The diagram below shows the effect on the equilibrium point of a decrease in the rate of interest.


The impact of monetary policy is affected by differences in the elasticity of the aggregate supply curve.


Using the Keynesian model of AS it is possible to highlight the changes in equilibrium price level and national income when moving from AD1 to AD2, and AD3 to AD4.


There is a greater amount of spare capacity in the economy between AD1 to AD2, than AD3 to AD4.  It is possible to show that these identical shifts in AD will have a different impact upon the equilibrium price level and national income.  When there is more spare capacity, AD1 to AD2, there will be a relatively small increase in the price level and a relatively large increase in national income.  When there is less spare capacity, AD3 to AD4, there will be a relatively large increase in the price level and a relatively small increase in national income.


The elasticity of the aggregate supply curve differs along the Keynesian AS curve.  It is possible to rewrite the previous paragraph highlighting the differences in the elasticity of the AS curve rather than spare capacity.  When the AS curve is relatively elastic, AD1 to AD2, there will be a relatively small increase in the price level and a relatively large increase in national income.  When the AS curve is relatively inelastic, AD3 to AD4, there will be a relatively large increase in the price level and a relatively small increase in national income.


The following diagrams show the monetarist model of AD and AS highlighting the effects of an identical increase in AD on a relatively elastic AS curve (SRASE) and a relatively inelastic AS curve (SRASI) on the diagrams below.  Again the we see a shift in AD when the AS curve is relatively elastic will lead to a relatively small increase in the price level and a relatively large increase in national income.


This compares to the diagram below where the AS curve is relatively inelastic, now there is a relatively large increase in the price level and a relatively small increase in national income.


Making Decisions About the Rate of Interest

The Monetary Policy Committee at the Bank of England meets every month to decide the official interest rate in the United Kingdom. The nine members of the MPC are:

  • The Governor of the Bank
  • The two Deputy Governors
  • The Bank’s Chief Economist
  • The Executive Director for Market Operations
  • Four external members, appointed by the Chancellor of the Exchequer for a renewable three year term


Each member has one vote of equal weight and can choose to raise the rate of interest, lower the rate of interest or keep the rate at its present level.  Meetings are held on the Wednesday and Thursday after the first Monday of each month. The interest rate decision is announced at midday immediately following the Thursday meeting. The minutes of the meetings explaining the reasons behind the decision and listing the votes of each member, are published on the Bank’s website after two-weeks.


Time Lags

Whilst it is important that the Bank is aware of what the rate of inflation is today, it knows that any changes it makes to the rate of interest will not immediately impact the economy due to the presence of time lags.  These time lags mean that it can be up to a year before changes in interest rates affect spending and saving decisions of individuals and businesses, and up to about two years before they affect the level of inflation.  Therefore, interest rates have to be set based upon what the MPC think the inflation rate might be in two years, rather than what it is today.


Fan Charts

The figure below is known as a fan chart; it is produced by the Bank of England to demonstrate what it thinks will happen to the rate of inflation if the rate of interest follows market expectations.  The Bank would expect inflation to lie within the darkest band 10% of the time and then there is a further 10% chance of being in each pair of bands as they become lighter.  There are nine shades in the fan chart, therefore there is also a 10% chance that inflation will fall somewhere in the unshaded area.  You can see that the width of the fan gets wider with time, this reflects the fact that there is greater uncertainty about what inflation will be in tree years time in comparison to three months time


Source: Bank of England Inflation Report.


The fan chart seems to imply that the MPC can simply look ahead two years and decide to lower interest rates if the central band is below the 2% target and raise the rates if it’s above.  Unfortunately monetary policy is not this simple!  Many factors effect the rate of inflation that the Bank is simply unable to foresee; this will mean that the fan chrt will be in accurate.


Factors the MPC Consider

In addition to using the fan charts and understanding the implications of time lags the MPC will consider a number of different areas of the economy:

  • Demand and output – the components of aggregate demand could lead to demand pull inflation if they grow too quickly.
  • The labour market – cost push inflation could arise if wages rise.
  • Costs and prices – cost push pressures will increase if component prices go up.
  • Financial markets – money supply and wealth effect could cause inflationary pressures.


The latest copy of the Bank of England’s Inflation Report explains the Bank’s decision as well as providing a wealth of economic information and data; it can be found on the Bank’s website.  In addition the Monetary Policy Committee releases the minutes that explains the Bank’s decision on its website.



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