Central Banks and the Tools of Monetary Policy
A central bank, in the UK the Bank of England, is the institution responsible for a country's monetary policy and, usually, for maintaining financial stability.
Before you start
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Method
- Learn the UK institutional set-up: the Bank of England, its Monetary Policy Committee, and the 2 percent CPI inflation target it is required to hit, with a remit to explain in writing if inflation is more than 1 percentage point away from target.
- Learn the transmission mechanism from a change in the base rate to the wider economy: a base rate change alters market interest rates, which changes the cost of borrowing, the reward for saving, and the exchange rate, which changes consumption, investment and net exports, which changes AD, which changes output and the price level.
- Learn quantitative easing (QE) as a tool used when the base rate is already very low, near its zero lower bound: the central bank creates new money to buy assets, mainly government bonds, from financial institutions, aiming to lower long-term borrowing costs and increase the money available for banks to lend.
- Learn forward guidance: a central bank stating its likely future policy stance to influence current spending and investment decisions by shaping expectations.
- Distinguish expansionary (loosening) monetary policy, cutting rates or QE, used to raise AD, from contractionary (tightening) monetary policy, raising rates or reversing QE, used to reduce AD and control inflation.
- Learn the argument for central bank independence: an operationally independent central bank, free from short-term political pressure to keep rates artificially low, is thought to make monetary policy more credible, helping anchor inflation expectations.
- Evaluate monetary policy using time lags, since interest rate changes are estimated to take around 18 months to 2 years to have their full effect on inflation, the size of the interest rate change relative to how indebted households and firms are, and the limits of policy when rates are already very low or when the shock is on the supply side.
Worked example
The Bank of England's Monetary Policy Committee raises the base interest rate. Explain the chain of effects, through the transmission mechanism, on the rate of inflation.
- A higher base rate raises the cost of borrowing and the reward for saving throughout the economy, as commercial banks adjust their own interest rates in line with it.
- Households and firms respond by borrowing and spending less, and saving more, so consumption (C) and investment (I) both fall.
- A higher UK interest rate also tends to attract more overseas savers seeking a better return, increasing demand for the pound and causing it to appreciate, which makes UK exports more expensive and imports cheaper, reducing net exports (X-M).
- Since C, I and X-M have all fallen, aggregate demand falls, shifting the AD curve leftward.
- At the new intersection with SRAS, both the price level and real output are lower than before, so the rate of inflation falls, or slows, which was the MPC's goal.
Practice questions
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Q1Which UK institution and committee is responsible for setting the base interest rate?Show answer
Answer: The Bank of England, through its Monetary Policy Committee (MPC).
Q2What is the UK's official inflation target?Show answer
Answer: 2 percent CPI inflation.
Q3What is quantitative easing?Show answer
Answer: The central bank creating new money electronically to buy financial assets, mainly government bonds, aiming to lower long-term interest rates and increase the money available for banks to lend, typically used when the base rate is already very low.
Q4What is forward guidance?Show answer
Answer: A central bank communicating its likely future policy path, e.g. how long interest rates will stay at a given level, to shape current spending and investment decisions through expectations.
Q5State one reason a central bank is often made operationally independent of the government.Show answer
Answer: To make monetary policy more credible, since an independent central bank is less likely to keep interest rates artificially low for short-term political reasons, helping anchor inflation expectations.
Q6Approximately how long is monetary policy generally thought to take to have its full effect on inflation?Show answer
Answer: Around 18 months to two years; there is a significant time lag.
Q7State one reason a rise in the UK interest rate is likely to cause the pound to appreciate.Show answer
Answer: A higher interest rate offers overseas savers a better return on pound-denominated assets, increasing demand for the pound on the foreign exchange market and raising its value.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain two limitations of using interest rate changes to control inflation.
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Evaluate the effectiveness of interest rate policy as a tool for controlling inflation in the UK economy.
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