3.6 Monetary policy

• Monetary policy


  The manipulation of the money supply or interest rates by the central bank in order to influence the level of total spending in the economy (AD), and therefore economic activity
• Objectives of monetary policy

  • A low and stable rate of inflation
  • Economic growth
  • Low unemployment
  • Stable balance of payments
• Bank of England


  The central bank of the UK, established in 1694 and the second oldest central bank in the world
• The Bank of England was granted the monopoly to print banknotes in England and Wales in 1844
• Bank of England's independence

  The Bank of England conducts its day-to-day operations independent of the government (since 1997)
• Functions of the Bank of England

  • Carries out monetary policy
  • Prints money
  • Oversees the financial system
  • Helps maintain the exchange rate for the sterling
  • Acts as a lender of last resort
• Bank rate (BoE base rate)


  The key interest rate set by the Bank of England, at which commercial banks can borrow from the BoE
• Monetary Policy Committee


  The committee of the Bank of England that meets every six weeks to decide on the bank rate
• The Bank of England's inflation target is 2% (±1%)
• The bank rate was lowered from 5% to 0.5% in 2009 and further to 0.1% during the pandemic
• A lower interest rate


  Increases consumption and investment, leading to higher aggregate demand
• The Bank of England has been raising interest rates in the past year to fight inflation
• Quantitative Easing (QE)


  The Bank of England buys UK government bonds or corporate bonds from financial companies and pension funds to lower interest rates when the bank rate is already very low
• A fall in interest rates

  Leads to a decrease in saving, an increase in household borrowing, lower mortgage repayments, an increase in investment by firms, an increase in asset prices, and a depreciation of the exchange rate
• A fall in interest rates


  Leads to an increase in some component of aggregate demand
• A fall in interest rates

  Leads to a decrease in unemployment
• Expansionary monetary policy


  A lowering of interest rate or a rise in the money supply, with the goal of increasing aggregate spending in the economy and hence try to increase output and employment
• Contractionary monetary policy


  An increase in the interest rate or a fall in the money supply, with the goal of decreasing aggregate spending in the economy and lower inflation
• Effects of expansionary monetary policy

  • Increase in economic growth
  • Decrease in unemployment
  • Increase in inflation
  • Depreciation of currency against foreign currencies
  • Depends on trade balance
• Effects of contractionary monetary policy

  • Decrease in economic growth
  • Increase in unemployment
  • Decrease in inflation
  • Appreciation of currency against foreign currencies
  • Depends on trade balance
• Expansionary monetary policy is likely to raise the inflation rate beyond 5% in Sri Lanka
• Contractionary monetary policy is likely to raise unemployment beyond 3% in the UK
• Factors affecting the effectiveness of changes in interest rates

  • Size and duration of the change in interest rate
  • Time lags in the effect on spending
  • Whether commercial banks change their interest rates
  • Expectations of consumers and firms
  • Accompanying fiscal policy
• A rise in interest rates in a fast-growing economy

  Will reduce demand-pull inflation, but high confidence may mean consumers don't save more and firms continue to invest
• Appropriate combination of fiscal and monetary policy can reduce policy conflicts