Monetary policy

• Monetary policy

  A policy that aims to control the total supply of money in the economy to try to achieve the government's economic objectives, in particular price stability
• The major objective of monetary policy is a low and stable rate of inflation
• Monetary Policy Committee (MPC)


  Operates monetary policy in the UK
• In the UK, the target is to keep inflation at 2% per annum (+/- 1.5%)
• Bank rate


  The Bank of England uses its bank rate to influence all other interest rates
• Monetary policy attempts to limit total demand for goods and services
• Interest rates


  The main tool of monetary policy
• In recent years quantitative easing has been used to get more money into the economy to encourage consumption and investment
• How monetary policy changes interest rates to achieve economic objectives

  1. Reduced interest rates

  2. Increased spending and borrowing by consumers

  3. Increased borrowing for investment by firms

  4. UK exchange rate falls

  5. Increased economic growth, employment and price stability
• When interest rates fall


  Spending and borrowing by consumers increases
• When interest rates fall

  Borrowing for investment by firms increases
• When interest rates fall


  UK exchange rate falls
• When interest rates rise

  Spending and borrowing by consumers decreases
• When interest rates rise

  Borrowing for investment by firms decreases
• When interest rates rise


  UK exchange rate rises
• The effects of monetary policy on consumer spending depend on the size of the change in interest rates
• The larger the change in interest rates, the more consumer spending is likely to be affected
• The UK's large mortgage sector tends to magnify the effects of changes in interest rates on consumer spending
• Effects of a fall in interest rates on consumer spending

  • Opportunity cost of spending falls, so consumers spend more and save less
  • Increase in disposable income for mortgage owners, so they can spend more
  • Retired people who rely on income from savings may spend less as their income falls
• The opposite effects will occur for a rise in interest rates
• Consumers borrow more to buy big-ticket items when interest rates fall
• A fall in interest rates may not lead to more borrowing if consumers lack confidence in the economy
• More people can afford to buy houses or larger houses when interest rates fall
• Effects of a fall in interest rates on saving


  • Consumption should rise and savings fall as the opportunity cost of consuming is less
  • If prices are falling, a cut in interest rates may not affect savings as people can consume more due to the price change
  • If the real rate of interest still exceeds the rate of inflation, people may save more as the value of savings is rising
• Factors affecting investment


  • Expected return from the investment
  • State of the economy
  • Competitors' investment decisions
  • Taxation on profits
• Monetary policy and economic objectives

  • The main tool is interest rates
  • In recent years quantitative easing has been used to put more money into the economy to encourage consumption and investment
• How monetary policy can affect growth

  1. Spending and borrowing by consumers increases

  2. Borrowing for investment by firms increases

  3. UK exchange rate falls
• How monetary policy can affect employment

  1. Spending and borrowing by consumers increases

  2. Borrowing for investment by firms increases

  3. UK exchange rate falls
• How monetary policy can affect price stability

  1. Spending and borrowing by consumers decreases

  2. Borrowing for investment by firms decreases

  3. UK exchange rate rises
• Effects of a fall in interest rates on borrowing

  • Consumers borrow more to buy 'big ticket' items
  • If consumers lack confidence, a cut in interest rates may not lead to more borrowing
  • More people can afford to buy houses or to buy larger houses
• Effects of a fall in interest rates on savings


  • Consumption should rise and savings fall
  • If prices are falling, a cut in interest rates may not affect savings
  • If the real rate of interest still exceeds the rate of inflation, people may save more
• Effects of monetary policy on investment

  • Two sources of money for investment are loans and retained profits
  • Other factors affecting investment: expected returns, state of the economy, competitors, taxation on profits