Definition
Monetary policy includes changes to interest rates, money supply and exchange rates.
Main functions of a central bank
The central bank in the UK is the Bank of England. It has the following functions:
- Sets monetary policy – this includes influencing interest rates, supply of money and credit (credit: buying goods and services now but paying later, often by borrowing), as well as the exchange rate.
- Banker to the government – the government can receive loans from the central bank.
- Lender of last resort or bankers to commercial banks. Commercial banks can deposit funds at the central bank or receive loans from the central bank.
- Regulates commercial banks. This includes regulations to make banks less likely to fail, such as requiring a bank to hold a minimum amount of reserves. [for more on this, see the financial market regulation page linked here]
Interest rates and the monetary policy transmission mechanism
An increase in Bank rate leads to higher interest rates throughout the economy.
[Bank rate is the interest for lending and borrowing between the Bank of England and commercial banks on the so-called “interbank” market. A higher Bank rate increases borrowing costs for commercial banks. To restore profit margins, commercial banks raise their interest rates for loans they offer. ]
Higher interest rates have the following effects:
- Increased reward for saving and cost of borrowing. Reduces consumption.
- Increased cost of borrowing reduces investment.
- Increased mortgage costs, which reduce demand for housing. This reduces house prices. As wealth has fallen, people feel less confident and so reduce consumption. This is a negative wealth effect.
- Higher interest rates increase demand for the domestic currency. This leads to an appreciation of the currency. This makes imports cheaper and exports dearer. So export demand falls and import demand rises. This may reduce net exports, further reducing aggregate demand.
Overall aggregate demand shifts left, leading to lower real GDP, higher unemployment and reduced inflation.
This can create a negative multiplier effect from the fall in investment. So AD shifts further left.
Because of the appreciation of the currency from higher interest rates, the current account deficit may grow.
But there may also be financial stability impacts. Borrowers have been used to low interest rates in the UK for over a decade, before recent Bank rate rises in the last few years. With high consumer debt and some consumers not being used to higher interest rates, there is a risk of a large group of consumers being unable to repay loans. If a proportion of consumers default on their debts all at once, this could cause lenders to fail and create “systemic risk” to the wider economy.
Evaluation points for increasing interest rates
The success of monetary policy depends on the following factors:
- Whether banks pass on the increase in Bank rate to depositors. Banks may not pass on rate rises to depositors to keep their costs low, particularly if consumers are not willing to switch banks quickly. This would reduce the extent to which depositors see a higher incentive to save when Bank rate rises.
- Inequality impacts. An interest rate rise makes savers richer but borrowers poorer. Savers are likely to be those with higher wealth. [On the other hand, higher interest rates may reduce asset values such as house prices].
- Some firms invest from retained profits rather than borrowing. So raising interest rates may not influence these firms as much.
- Relative interest rates – for a currency to appreciate, domestic interest rates must rise relative to foreign interest rates. While the Bank of England was raising interest rates in the second half of 2022, the US central bank, the Federal Reserve, was also raising rates, contributing to the depreciation of the pound in this period. If interest rate rises do not lead to an appreciation, then we may not necessarily see net exports decrease.
- Levels of debt or savings in the economy. If debt is high relative to incomes, then raising interest rates is more likely to harm living standards of consumers, who are more likely to be unable to repay debts. As a result, financial stability risks may be greater.
- Level of spare capacity / position on the Keynesian AS curve. If there is high spare capacity and interest rates fall, there is likely to be little increase in inflation, as the spare capacity absorbs excess aggregate demand.
- State of fiscal policy. If interest rates are rising while fiscal policy is expansionary, then interest rates rising may not be enough to bring down inflation.
- Proximity of interest rates to the zero lower bound (or more precisely, the “effective lower bound”). Cash under the sofa effectively gets zero percent interest. So if interest rates go too negative, depositors will just withdraw money from banks and keep it at home. This would cause a “bank run”, possibly leading to bank failure. So interest rates can only go so low, before they cannot go any lower.
- Time lags – interest rate changes can take up to two years to feed through to the rest of the economy.
The factors considered by the MPC when setting the bank rate
The Monetary Policy Committee (MPC) meets eight times a year to set monetary policy. There are nine voting members who vote on policy decisions, such as whether to change interest rates.
Factors that the MPC considers:
- Inflation – the MPC has an inflation target of 2% CPI (plus or minus one percentage point) over the medium term. High inflation may mean the MPC raises Bank rate.
- Subject to achieving price stability, the MPC has an objective of supporting the government’s macroeconomic objectives. This includes sustained economic growth and full employment. The MPC can decide to allow inflation to deviate from target temporarily, if that prevents significant volatility in output.
- Other objectives can include financial stability (preventing the failure of financial institutions like banks) or net zero emissions.
- In forming a judgement about monetary policy, the MPC may also consider the various factors that contribute to inflation and other objectives, such as:
- Commodity prices.
- The labour market, including wage growth and labour market “tightness”.
- Exchange rates.
- The stance of fiscal policy.
- The extent of consumer or business debt.
This document here shows the Bank of England’s remit from the UK Government.
How the Bank of England can influence the growth of the money supply.
By lowering Bank rate, the central bank makes it cheaper for commercial banks to borrow from the central bank. This gives the banks more funds to loan out, increasing the money supply.
If the central bank buys government bonds from commercial banks, this also increases the amount of funds available to commercial banks, again increasing money supply. Quantitative easing (see below) is one way to do this.
Note that modern banking is typically “fractional reserve banking”. This means that when a bank receives funds from the Bank of England or from customer deposits, it only keeps a small fraction in reserve. The rest of the funds the bank lends out to someone else, who then deposits funds in another account. Most of these deposits are then loaned out again.
Altogether, this means the total money supply increases by more than the initial increase in money supply from the central bank.
Quantitative Easing
Bonds
Firstly it’s worth understanding government bonds.
A government bond is a loan from the bondholder to the government.
Someone buys a bond from the government for say £100. This allows the government to borrow about £100. But the bondholder now gets a “coupon” payment at regular intervals, say £1 a year.
When the bond expires, say after 10 years, the original loan is fully returned at once to the bondholder. In this simple case, the bondholder receives £1 a year for 10 years, then receives a final payment back of £100 at the end of the 10 years.
Bond prices and interest rates have a negative relationship. For more on this, I will post a separate article on bonds and financial markets*.
Government bonds, in the example above, were traded on the “primary market”. This is where the government sells the bonds directly.
For quantitative easing, we are concerned with the “secondary market”. This is where bondholders buy and sell bonds among themselves.
How QE works
Quantitative easing (QE) has the following steps:
- Central bank creates digital money.
- Central bank uses this digital money to buy government bonds from financial institutions, like banks and pension funds.
- This gives financial institutions more to spend, so they may give out more loans to businesses and households.
- Alternatively, financial institutions may put their extra funds into buying corporate bonds (just like a government bond, except a company can create a bond to borrow too). This increases demand for corporate bonds, raising their price but lowering their interest rate. This makes it cheaper for firms to borrow, increasing investment.
- Overall, investment and consumption increase, so aggregate demand shifts right. This leads to higher inflation and higher real GDP.
At its peak, the Bank of England has £895 billion of quantitative easing on its books. This was mainly government bonds but also a smaller amount of corporate bonds.
Beyond bonds, banks might invest in:
- Stocks (small part of a company).
- Capital goods (machinery).
- More loans.
- Property.
- Currencies, commodities (metals, oil).
As a result, those who do own assets, such as houses, are likely better off from QE. This may generate a positive wealth effect for this group. Higher asset values mean households are richer, so consumption goes up.
Note there is another effect of QE. By buying government bonds from commercial banks, it increases bond demand, decreasing bond interest rates. This makes it cheaper for the government to borrow.
Some issues with QE
- Inflation rising too high. Some economists attribute high inflation in the world economy in 2022 and 2023 to a decade of expansionary monetary policy, including QE.
- Inequality – QE makes banks and financial institutions richer. Those with assets benefit from rising asset prices. Ordinary citizens, including those without much in the way of assets, may not benefit at all. In fact, if house prices rise as a result of QE, they are worse off – it is more difficult for them to afford a house.
- Note the Bank of England argues that because QE increased employment and incomes, QE benefitted low and middle incomes groups too.
- Higher investment in riskier assets – currencies, commodities, cryptocurrency. These are very volatile. People are more likely to lose money and this creates financial stability risks. There is the possibility of asset price “bubbles” – asset prices rise above their fundamental value.
One advantage of QE is that it is reversible. The reverse of QE is called “quantitative tightening” or QT.
In QT, the central bank sells bonds to private banks or other agents. This reduces the amount of bank funding available for loans, so there is less borrowing, lower investment and lower AD.
Evaluation points for QE
The success of QE depends on:
- Spare capacity / position on Keynesian AS curve – if the economy has high spare capacity, then increases in real GDP (because of higher AD) have lesser effect on inflation.
- How financial institutions allocate their new income. Which assets this income goes towards or whether banks hold on to extra funds.
- The degree of wealth inequality. Greater wealth inequality means the benefits from QE are more likely to accrue to those with assets, such as bonds, stocks or housing, further increasing inequality.
- Whether or how long it takes for QE to be reversed. If QE is maintained, then the inequality effects are more likely to be permanent.
For a long report on QE in the UK, see the link here.
Other monetary policies
Funding for Lending
The Funding for Lending scheme was launched in 2012. The Bank of England, working with the UK Government, provided funds at below market interest rates to commercial banks. This was to encourage banks to give out more loans (“supply more credit”) and make loans cheaper for consumers and businesses.
Over the period of the Funding for Lending scheme from 2012 to 2014, there was a decrease in the cost of borrowing funds.
However some banks did not take up this extra funding, claiming they had enough of their own funds and it was simply that businesses weren’t willing to borrow.
Other banks were accused of sitting on the funds and not lending it out.
Forward guidance
Forward guidance is when the central bank gives messages about the future direction of monetary policy.
For example the central bank can state that interest are likely to rise (or fall) in the future, or that interest rates will not rise until a particular condition is met.
Manipulating expected future interest rates can influence the cost of borrowing and reward for saving, which can affect consumption and investment today.
An example is the Bank of England announcing in 2013 they would not raise interest rates unless unemployment fell below 7%. To read more on this, check out the link here.
For forward guidance to be effective, the forward guidance being given must be credible to lenders and borrowers. If economic agents do not believe what the Bank of England say, they will not pay any attention to the forward guidance.
Helpful resources
Check out the following links below for more A-level Economics resources for AQA and Edexcel:
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