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Money video
The Bank of England and
Monetary Policy
Government Economic Policy
• Monetary Policy
• Fiscal Policy
• Supply-side Policies
Aims of the Bank of England
• To oversee the financial system
• To implement monetary policy
Monetary Policy
• Aims to achieve the Governments macroeconomic objectives using MONETARY
POLICY INSTRUMENTS:
• Interest rates
• Controls over bank lending
• Exchange rates
• Money supply – recently Quantitative Easing
• Prior to 1997 Monetary Policy was
implemented more or less jointly by the
Government and the Bank of England (B
of E)– ‘the monetary authorities’
• In 1997 the B of E was made
operationally independent, and is now
the sole monetary authority in the UK
Monetary Policy Objectives
• For over 30 years, the control of inflation has
been the main objective of Monetary Policy in
the UK – the inflation target set by the
Government 2% CPI is the main policy
objective
• Low and stable inflation helps to create the
conditions in which the economy can flourish
and achieve the ultimate objective of
improved economic welfare for everyone
Other Monetary Policy
Objectives
• At the present time these are not used,
however:
• 1979 to 1985 the Thatcher Government
experimented with MONETARISM and
tried to control the MONEY SUPPLY in
order to control inflation
• 1985 to 1992 the EXCHANGE RATE was
used as the intermediate policy objective
to control inflation, until the £ was forced
out of the ERM
Monetary Policy Instruments
• Broadly, these are separated into those
that:
• Affect the supply of new deposits that
the commercial banks can create
• Influence the demand for loans or
credit
Controlling the Supply of
Loans and Credit
• Direct controls on bank lending – both a
‘qualitative’ and a ‘quantitative’ approach may
be adopted
• These were abolished in the 80s, as the
Government believed that ‘free’ market
policies were more efficient than
interventionist policies – more recent policies
have encouraged banks to lend to stimulate
business borrowing e.g. RBS directive
Using Interest Rates to Influence
the Demand for Loans and Credit
• Modern monetary policy operates almost
solely through the use of interest rate
policy
• The B of E rations demand for credit by
raising or lowering its official rate of
interest, and therefore affects the
level of AD in the economy via the
money transmission mechanism
The Bank of England as
‘Lender of the Last Resort’
• The B of E is the commercial banks’ banker
• At a price – the lending rate or ‘repo’ rate - it
supplies cash to the commercial banks by
purchasing some of their reserve assets e.g.
’bills’ and ‘gilt edged securities’
• The banks then repurchase these bills later
and ‘return’ their surplus cash to the B of E
The ‘Repo’ Rate
• The B of E’s official rate, base rate or
lending rate is also called the ‘repo’ rate
• The word ‘repo’ is short for sale and
repurchase agreement – as explained on
the previous slide
Using Interest Rates to Implement
Monetary Policy: An Increase in the
Interest Rate
• This means it more expensive for
commercial banks to obtain cash from
the B of E
• The banks increase the rate of interest
they charge to their own customers
• Loans and credit become more
expensive
Using Interest Rates to Implement
Monetary Policy: An Increase in the
Interest Rate
• There is a fall in demand for loans and
credit
• There is a reduction in total bank
deposits and therefore the money
supply in the economy
• In addition, existing loan repayments
become more expensive reducing
disposable income
Using Interest Rates to Implement
Monetary Policy: An Increase in the
Interest Rate
• Investment projects become less
attractive
• There is a fall in aggregate demand
• This eventually reduces the inflation
rate
Pre-emptive Monetary Policy
• Since 1992 monetary policy has been directed
at a published inflation target – currently 2%
CPI
• The B of E will increase the interest rate
even when there is no immediate sign of
accelerating inflation, in order to ‘pre-empt’ a
rise in inflation that would otherwise occur
many months ahead
Pre-emptive Monetary Policy
• The B of E committee members estimate
what they believe the rate of inflation will be
in 18 months to 2 years time
• If the forecast rate is different from the
target rate they will change interest rates
accordingly
• In addition, they will alter rates to pre-empt
or head-off any likely adverse effects of an
outside shock on the economy
Monetary Policy Since 1997
• The granting of operational
independence to the B of E, and the
creation of the MPC within the bank to
implement monetary policy
• Their role is to set interest rates in
order to meet the Government’s
published inflation target
Monetary Policy Since 1997
• The MPC was made accountable for any
deviations from the target rate of inflation
• If inflation is more than 1% point higher or
lower than the target, then the Governor of
the B of E has to write an ‘open letter’ to the
Chancellor explaining why
• The letter must be published to promote
transparency
Monetary Policy Since 1997:
The Symmetrical Target
• This means that when the inflation rate is
below or is predicted to fall below the target,
then the MPC must stimulate aggregate
demand in the economy by reducing interest
rates and raising the rate of inflation
• Similarly, when inflation is above or is
predicted to rise above the target, then the
MPC must increase interest rates to reduce
aggregate demand in the economy
Neutral, Contractionary and
Expansionary Monetary Policy
• Neutral monetary policy is where
interest rates neither boost nor hinder
aggregate demand
• Where the economy is growing on or
around its sustainable trend rate of
growth, without negative or positive
output gap
Neutral, Contractionary and
Expansionary Monetary Policy
• Contractionary policy is consistent with
a positive output gap, when actual
output is above the trend rate of
growth
• Expansionary policy is consistent with a
negative output gap when output is
below that required at the trend rate