- Monetary Policy involves using interest rates and other monetary tools to influence the levels of consumer spending and Aggregate Demand (AD).
- In the UK the target of Monetary policy is to keep inflation within a target of CPI 2% +/-1. They also consider other macroeconomic variables such as growth and unemployment.
- UK Monetary Policy is set by the Monetary Policy Committee (MPC) of the Bank of England. They are independent in setting interest rates, but have to try and meet the government’s inflation target.
- Details on how the Bank of England set the interest rates
During the credit crunch of 2008-09, the Bank of England also used Quantitative Easing as a part of monetary policy. This involves creating money electronically to buy assets (such as government bonds from banks). It is hoped by buying illiquid assets there will be an increase in the money supply and avoid deflationary pressures.
Recent Base Rates in UK and Economic Growth
How Monetary Policy Works
The Bank of England study inflationary trends in the economy. This involves looking at a range of economic variables
- Unemployment, consumer confidence, spare capacity in the economy, exchange rate index, house prices, economic Growth
From these statistics, the Bank of England decides whether inflation is likely to rise or fall.
- If they expect higher inflation and higher growth, they will tend to increase interest rates.
- If they expect lower growth and a fall in the inflation rate, they will tend to cut interest rates.
Loose Monetary Policy
If the Bank of England anticipates inflation falling below the governments target of 2% and economic growth is sluggish or the economy is facing a recession. They are likely to cut interest rates.
Lower interest rates in theory, should stimulate economic activity. This is because lower interest rates reduce borrowing costs. This increases the disposable income of consumers with mortgage interest payments and should encourage spending.
Tight Monetary Policy
If the Bank feels the economy is growing too quickly and inflation is expected to exceed the governments target, then they are likely to increase interest rates to reduce the rate of growth and inflationary pressures.