monetary policy - introduction

What is Monetary Policy?

Monetary Policy involves changes in the base rate of interest to influence the rate of growth of aggregate demand, the money supply and ultimately price inflation.

Monetarist economists believe that monetary policy is a more powerful weapon than fiscal policy in controlling inflation. Monetary policy also involves changes in the value of the exchange rate since fluctuations in the currency also impact on macroeconomic activity (incomes, output and prices)

Changes in short term interest rates affect the spending and savings behaviour of households and businesses over time and therefore feed through the circular flow of income and spending. The transmission mechanism of monetary policy works with variable time lags depending on the interest elasticity of demand for different goods and services – e.g. the demand for interest-sensitive consumer goods and services bought on credit or the demand for capital investment from private sector businesses. Because of the time lags involved in setting an appropriate level of short-term interest rates, the Bank of England sets nominal interest rates on the basis of hitting the inflation target over a two year forecasting horizon.

Monetary Policy in the UK

Quote: Mervyn King on Monetary Policy’s Role in Britain

"What is the mechanism by which monetary policy contributes to a more stable economy? I would argue that monetary policy is now more systematic and predictable than before. Inflation expectations are anchored to the 2.5% target. Businesses and families expect that monetary policy will react to offset shocks that are likely to drive inflation away from target. In the jargon of economists, the “policy reaction function” of the Bank of England is more stable and predictable than was the case before inflation targeting, and easier to understand.4 More simply, monetary policy is not adding to the volatility of the economy in a way that it did in earlier decades"

Adapted from “The Inflation Target – Ten Years On” a speech given by Mervyn King in October 2002-12-19

Day-to-day operation of monetary policy in the UK is in the hands of the Bank of England (granted independence in setting interest rates in May 1997). The Bank sets the official repo rate on the basis of a detailed monthly assessment of trends in the macro-economy and the associated balance of risks to cost and price inflation.

The Bank’s Quarterly Inflation Report (available for free download from the Bank’s own web site) outlines the Bank’s current projections for inflation. The government has set an explicit inflation target (2.5% +/- 1% for RPIX inflation – reaffirmed after the 2001 General Election) which now forms the basis for monetary policy decisions.

Monetary Policy and the Exchange Rate

There is no official exchange rate target for the British economy. The UK has operated a free-floating exchange rate since we suspended our membership of the European exchange rate mechanism in September 1992 and although the Monetary Policy Committee has occasionally discussed the relative merits and de-merits of intervening in the current markets to influence the external value of the pound, the Bank has not done so for over a decade. There are in any case severe doubts about the effectiveness of direct intervention in the foreign exchange markets.

Monetary Policy and Money Supply Targets

There are no specific targets for the growth of the money supply (M0, M4) – although data on the growth of the stock of money provides useful information for the MPC on the strength of aggregate demand. Interest rates are not determined with reference to specific targets for the money supply. There are no supply-side controls on the growth of bank lending/credit instead monetary policy in the UK is designed to control the growth in the demand for money through changing the cost of loans and influencing the incentive to save.

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monetary policy - introduction

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