Monetary Policy

You might have noticed a relatively recent post-pandemic price hike, which the Bank of England aimed to slow down by increasing interest rates to 0.5% in February 2022.¹ This is an example of monetary policy: the Central Bank controls the interest rates to ultimately influence the rate of inflation in the whole economy. Want to learn more? Then read on.

Monetary policy: meaning

Monetary policy is a demand-side policy. It is a type of policy that allows the government to manipulate the interest rate and alter the money supply to change the level of aggregate demand and achieve its macroeconomic objectives.

Before 1997, the Treasury Department in the government along with the Bank of England were responsible for setting monetary policy. However, since 1997 the Bank of England is in charge of the operational tasks and in charge of the nation’s monetary policy, and the Treasury only sets a ‘target’.

It is important to distinguish the Bank of England from other banks like Barclays or HSBC.

The Bank of England is a central bank that has the authority to change the interest rates and exchange rates and make changes to the money supply. Banks like Barclays or HSBC are commercial banks whose main operations are conducted to make a profit for their owners.

The Bank of England, a central bank, controls the banking system and implements the monetary policy on behalf of the government.

The instruments of monetary policy

The main monetary policy instrument that the Bank of England uses is the ‘Bank rate’. The Bank rate is the rate of interest the UK's central bank pays to other commercial banks like Barclays and HSBC on the deposit these commercial banks hold at the Bank of England.

The monetary policy committee (MPC) either raises or lowers the bank rate (by a quarter of 1%) every month while simultaneously leaving interest rates unchanged to keep inflation rate levels above 1% or below 1%.

The CPI target rate (the inflation rate that the UK aims to have) has remained at 2% since 2003.

The monetary policy concerning interest rates is usually based on the demand for credit and loans. When the central bank decides to increase interest rates, people will be less likely to borrow money as the cost of borrowing has increased.

Conversely, if the central bank decides to lower the interest rates, the cost of borrowing money decreases. Hence, more people will be likely to borrow. Ultimately, changes in interest rates will affect aggregate demand.

Monetary policy objectives

One central objective that the Bank of England has is to control inflation. This is the main monetary policy objective and the rate of interest is the principal monetary policy instrument they utilise.

Controlling inflation in the UK is seen as a means of creating ‘sound money’ that is deemed necessary for the economy. The end goal is creating and setting higher economic standards.

Expansionary monetary policy

Whereas fiscal policy can affect aggregate demand by using government spending, monetary policy can affect aggregate demand by changing interest rates, exchange, and money supply.

Let’s briefly look at the aggregate demand formulae:

As we said, fiscal policy can affect AD through government spending (G). Monetary policy can affect other components of the AD primarily the components of Consumption (C), Investments (I), and Net Exports (X-M) (changes in Net exports can happen due to exchange rate changes).

In expansionary monetary policy, the central bank decreases interest rates to inject more income into the circular flow of income and to stimulate aggregate demand.

Here the central bank is encouraging consumption (C), borrowing, and investment(I) spending and discouraging savings as the cost of borrowing loans and credits has become cheaper. Exports (X-M) also increase as other countries find it cheaper to buy the country’s goods and services since interest rate reduction causes the exchange rate to depreciate relative to other currencies.

This exchange rate change makes exports more internationally price competitive as it is easier to buy your country's goods and services while simultaneously making imports less competitive.

We can use a graph to illustrate the effects of the enactment of expansionary monetary policy. Check Figure 1 below.

Figure 1. Expansionary Monetary Policy, StudySmarter Originals

Let’s suppose the Bank of England with the MPC committee has decided to reduce interest rates to encourage more borrowings, investment, and consumption as the cost of borrowing money has become cheaper and more attractive for households and firms.

There is also a need to find new markets to export British-made goods and services ever since the advent of Brexit. Hence, the intention is to increase overall exports and remain competitive in the global economy.

With these changes in mind, considering that consumption, investments, and net exports, components of aggregate demand will increase, it will then shift the AD curve outward (to the right) from AD1 to AD2. The size of the shift depends on the size of the multiplier effect.

As the economy sees an increase in aggregate demand, shown by the movement from point A to point B, real output increases from Y1 to Y2 and we also see a price level increase of P1 to P2. The extent to which both price level and real GDP increase depend on the slope of the long-run aggregate supply curve (LRAS).

In this scenario, the implementation of expansionary monetary policy will increase the overall real output (real GDP) and increase the availability of jobs which will simultaneously results in increased employment levels.

Contractionary monetary policy

When using a contractionary monetary policy, the government increases interest rates to decrease the level of aggregate demand in the economy. The implementation of contractionary monetary policy can be a result if the economy sees too strong growth that ends up causing high inflation levels.

When the central bank increases its interest rates, the cost of borrowing loans and credits for households and firms increases. This will in short term discourage consumption; borrowings, investments, and imports are likely to increase. Imports will rise as the exchange rate will appreciate which will, in turn, discourage other countries to buy goods and services as the currency has become more expensive. This change will make exports less competitive and imports more competitive.

Let’s assume the Bank of England has decided to increase interest rates. This, in turn, increased the cost of borrowing loans and credits which will discourage households’ consumption and firms’ investment as well as increase imports (that will likely result in a budget deficit). All of these components of aggregate demand will decrease and we can illustrate a representation of this change below in Figure 2.

Figure 2. Contractionary monetary policy, StudySmarter Originals

A decrease in these components, which are some of the key components of aggregate demand, will cause the aggregate demand curve to shift inward (to the left) from AD1 to AD2. This also causes real output to decrease from Y1 to Y2 and general price levels fall from P1 to P2.

A decrease in real output and a decrease in price levels due to a contractionary monetary policy can cause recessions in the long run, as the main goal initially was to control inflation. The likelihood of the recession occurring can increase due to the multiplier effect as well. This in the end causes the economy to move from point A at an operating level to point B.

Examples of monetary policy

One example of monetary policy implementations includes interest rate changes. The Bank of England can either increase or decrease them to achieve its macroeconomic objective of keeping inflation in check.

An additional example is exchange rate changes. Here, the Bank can cause the currency to appreciate or depreciate in order to control the balance of payment budgets.

A final recent example was when the US federal reserve (the policymakers responsible for interest rate policy in the USA) sold government bonds and other securities through market operations.

Monetary policy vs fiscal policy

Fiscal policy, often associated with Keynesian economic theory, is a section of the government's overall economic policy which aims to achieve its economic objectives through the use of fiscal instruments such as taxation, public spending, and a budgetary position.

Sources

1. Bank of England - Monetary Policy Summary, February 2022.