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AS Macroeconomics / International Economy

Monetary Policy

Monetary policy influences the decisions that we make about how much we save, borrow and spend.

What is Money?

Money is defined as any asset that is acceptable as a medium of exchange in payment for goods and services.  The main functions of money are as follows:

1. A medium of exchange used in payment for goods and services
2. A unit of account used to relative measure prices and draw up accounts
3. A standard of deferred payment – for example when using credit to purchase goods and services now but pay for them later
4. A store of value - money holds its value fairly well unless there is a situation of accelerating inflation. As the general price level in the economy rises, so the internal value of a unit of currency decreases.

Interest Rates

There is no unique rate of interest in the economy. For example we distinguish between savings rates and borrowing rates.  However interest rates tend to move in the same direction. For example if the Bank of England cuts the base rate of interest then we expect to see lower mortgage rates and lower rates on savings accounts with Banks and Building Societies.

The Real Rate of Interest

The real rate of interest is often important to businesses and consumers when making spending and saving decisions. The real rate of return on savings, for example, is the money rate of interest minus the rate of inflation. So if a saver is receiving a money rate of interest of 6% on his savings, but price inflation is running at 3% per year, the real rate of return on these savings is only + 3%.

The Job of Monetary Policy

“…to deliver price stability (as defined by the Government’s inflation target) and, subject to this objective, to support the Government’s economic policy, including its objectives for economic growth and employment…”

The Bank of England has been independent since 1997. In that time there has been a cycle of small changes in interest rates. They have varied from 3.75% (in the late autumn of 2003) to 7.5% in the autumn of 1997. Generally though, the UK economy has experienced a sustained period of low interest rates over recent years. And, this has had important effects on the wider economy.

The Bank of England prefers a gradualist approach to monetary policy – believing that a series of small movements in interest rates is a more effective strategy rather than sharp jumps in the cost of borrowing money. Their aim is not to shock consumers and businesses to control their spending, but to gradually increase the cost of borrowing money and increase the incentive to save, so that the pace of growth moderates and the economy can continue to grow without causing rising inflation.

Factors considered when setting interest rates

1. The State of Demand: Is aggregate demand too strong – for example is household spending booming at an unsustainable rate?
2. The Housing Market: What are the economic signals coming from the housing market? If house prices rising too strongly, this might feed through into increased consumer demand and the risk of a surge in demand-pull inflation.
3. The Labour Market: Are their inflationary signals coming from the labour market in the form of acceleration in wages and average earnings well above the growth of labour productivity?
4. Inflation from overseas: Is there a risk from import costs such as a rise in oil prices?
5. Trends in the Exchange Rate: What is happening and what is projected to happen to the sterling exchange rate?

It is important to note that monetary policy in Britain is designed to be pro-active and forward-looking. This means that the MPC is aware that changes in interest rates take time to work through the economic system. Making decisions on interest rates on the basis of today’s inflation data simply does not make sense. The teams of economists at the Bank must make regular forecasts of inflation and consider whether the current level of UK interest rates is appropriate in order to meet the inflation target.

Interest rate changes since 1997

Effects of Changes in Interest Rates

There are several ways in which changes in interest rates influence aggregate demand. These are collectively known as the transmission mechanism of monetary policy.

One of the principal channels that the MPC can use to influence aggregate demand, and therefore inflation, is via the lending and borrowing rates charged by the market.

When the Bank’s base interest rate rises, banks will typically increase both the rates that they charge on loans, and the interest that they offer on savings. This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend — and so depresses aggregate demand. Conversely, when the base rate falls, banks tend to cut the market rates offered on loans and savings. This will tend to stimulate aggregate demand.

Changes to the level of interest rates take time to have an impact on overall economic activity - i.e. there is a time lag involved. A change in interest rates can have wide-ranging effects on the economy.

The Bank’s view of the transmission mechanism resulting from a change in official base interest rates is shown in the flow chart above – the key to it is that short-term changes in interest rates feed through fairly quickly to the rest of the UK financial system (e.g. resulting in changes in mortgage interest rates, rates of interest on savings accounts and also credit card rates) and then start to influence the spending and savings decisions of millions of households and businesses.

A key influence played by rate changes is the effect on confidence – in particular household’s confidence about their own personal financial circumstances.

1. Housing market & house prices: Higher interest rates increase the cost of mortgages and eventually reduce the demand for most types of housing. This will slow down the growth of household wealth and put a squeeze on equity withdrawal (consumers borrowing off the back of rising house prices) which adds directly to consumer spending and can fuel inflation
2. Effective disposable incomes of mortgage payers: If interest rates increase, the income of homeowners who have variable-rate mortgages will fall – leading to a decline in their effective purchasing power. The effects of a rate change are greater when the level of existing mortgage debt is high, leading to a rise in debt-servicing burdens for home-owners. On the other hand, a rise in interest rates boosts the disposable income of people who have paid off their mortgage and who have positive net savings in bank and building society accounts.
3. Consumer demand for credit: Higher interest rates increase the cost of servicing debt on credit cards and should lead to a deceleration in the growth of retail sales and spending on consumer durables. Much depends on the impact of a rate change on consumer confidence.
4. Business capital investment: Firms often take the actual and expected level of interest rates into account when deciding whether or not to proceed with new capital investment spending. A rise in short term rates may dampen business confidence and lead to a reduction in planned capital investment. However, many factors influence investment decisions other than rate changes.
5. Consumer and business confidence: The relationship between interest rates and business and consumer confidence is complex, and depends crucially on prevailing economic conditions. For example, when businesses and consumers are worried about the risk of a recession, an interest rate cut can boost confidence (and therefore aggregate demand) because it reassures the public that the Bank is alert to the dangers of an economic slump. There are circumstances, however, where a cut in rates could undermine confidence. For example, were the Bank of England to cut interest rates too quickly, the fear might be that the Bank is particularly worried about the prospects of a recession. The setting of interest rates nearly always calls for a finely balanced judgement, particularly when the effects on consumer and business confidence are concerned.
6. Interest rates and the exchange rate: Higher UK interest rates might lead to an appreciation of the sterling exchange rate particularly if UK interest rates rise relative to those in the Euro Zone and the United States attracting inflows of “hot money” into the British financial system. A stronger exchange rate reduces the competitiveness of UK exports in overseas markets because it makes our exports appear more expensive when priced in a foreign currency (leading to a decline in export volumes and market share). It also reduces the sterling price of imported goods and services leading to lower prices and rising import penetration. If the trade deficit in goods and services widens, this is a net withdrawal of demand from the circular flow and acts to reduce excess demand in the economy.

Usually a UK interest rate cut will tend to weaken the pound as it makes it less attractive for foreign investors to hold their money in Britain.

When the pound rises, British exports become more expensive, while imported goods from abroad become cheaper. So a rising pound leads to a fall in demand for UK exports and a fall in demand for domestically produced goods that compete with imports from overseas. A rising pound therefore reduces aggregate demand, and so can dampen down the rate of inflation. An increase in the pound also affects the inflation rate directly by bringing down the price of imported goods.

Monetary Policy Asymmetry

Fluctuations in interest rates do not have a uniform impact on the economy. Some industries are more affected by interest rate changes than others (for example exporters and industries connected to the housing market). And, some regions of the British economy are also more exposed (sensitive) to a change in the direction of interest rates.

The markets that are most affected by changes in interest rates are those where demand is interest elastic in other words, market demand responds elastically to a change in interest rates (or indirectly through changes in the exchange rate).

Good examples of interest-sensitive industries include those directly linked to demand conditions in the housing market¸ exporters of manufactured goods, the construction industry and leisure services. In contrast, the demand for basic foods and utilities is less affected by short term fluctuations in interest rates.

The rate of interest is under the control of the Bank of England, but most other economic variables are not! The MPC’s decisions can influence consumer and business behaviour but it cannot determine directly the rate of inflation.