8.3 Central Banks and Monetary Policy
How do Lower Interest Rates increase Household Consumption?
First, lower interest rates discourage saving, which means that more income is available for consumption. Second, the cost of household borrowing falls, which cuts the cost of servicing a mortgage and credit card debt. Borrowers have more money to spend on consumption because less of their income is used for interest payments. Third, lower interest rates may cause asset prices, such as the prices of houses and shares, to increase. Higher house and share prices increase personal wealth, which in turn increases consumption because people feel wealthier. Fourth, rising house and share prices lead to an increase in consumer confidence, which further boosts consumption.
What is the Relationship between Changes in Interest Rates and the Exchange Rate?
A fall in UK interest rates causes financial capital to flow out of the pound and into other currencies in search of better rates of return. This reduces the demand for pounds and increases the supply of pounds on the FX market, which in turn causes the pound's exchange rate to fall. Changes in export and import prices brought about by a fall in the exchange rate affect inflation in two ways. First, a falling exchange rate increases the prices of imported food and consumer goods. This increases the rate of inflation in the UK. At the same time, increased prices of imported raw materials and energy create cost-push inflationary pressures in the UK (import cost-push inflation). Second, a falling exchange rate reduces UK export prices, while raising the price of imports. This feeds into the inflationary process described above, by increasing the demand for UK exports and persuading some UK residents to buy more home-produced goods and fewer imports. This adds to demand-pull inflationary pressures. It is also likely to improve the UK's balance of payments on current account.
What does a Rise in Interest Rates do?
A rise in interest rates makes it more attractive for overseas residents to 'save' with UK financial institutions, triggering a short-term capital inflow on the balance of payments, which increases the exchange rate. Exports lose their competitiveness, and the current account of the balance of payments deteriorates. AD falls and the AD curve shifts to the left.
Define Quantitative Easing
An unconventional form of monetary policy through which a central bank, such as the Bank of England, creates new money electronically which it then uses to buy financial assets, such a government bonds, on the country's financial markets. also known as the Asset Purchase Scheme.
What is Forward Guidance?
Attempts to send signals to financial markets, businesses and individuals, about the Bank of England's interest rate policy in the months and years ahead, so that economic agents are not surprised by a sudden and unexpected change in policy. Using the policy, the gov aims to calm uncertainty in otherwise jittery financial markets. If the Bank of England signals that it intends to keep rates low, the Banks can engineer an outcome in which interest rates are kept low when markets fear that interest rates are moving higher. By altering expectations favourable, forward guidance aims to improve the credibility of monetary policy, thereby enabling households and businesses to feel calmer about their future economic prospects. According to the Bank, forward guidance means companies and mortgage borrowers can estimate for how long low interest rates will be around. If this is achieved, forward guidance is a way of converting low short-term interest rates into lower long-term interest rates. If traders in financial markets perceive the strategy to be 'wishful thinking', forward guidance could damage rather than increase the credibility of the Bank of England in its management of the UK economy. Also loses credibility if the BofE repeatedly 'moves the goal posts' - that is, changes policy every few months in the light of unexpected events hitting the economy. For cynics, FG has introduced a new uncertainty for expectations on the future path of interest rates.
How can the Bank Rate be used to Manage Demand for Credit?
Bank Rate is the minimum rate of interest charged when the Bank of England lends money to the commercial banks to enable the banks to maintain their liquidity. However, the rate charged is usually above Bank Rate and the banks also have to deposit securities, such as gov bonds, with the Bank of England as collateral. An increase in Bank Rate makes it more expensive for banks to borrow from the BofE and the banks will usually have to increase the interest rates they charge when lending to the general public. Likewise, a cut in Bank Rate usually leads to a fall in the interest rates charged by the banks. In this way, changes in Bank Rate cause changes in other short-term interest rates (though less so in long-term interest rates such as the yield on government bonds or gilts). Two factors affecting interest rates are time and risk. As a general rule, long-term interest rates are higher than short-term interest rate because lenders are sacrificing their ability to spend their own money for longer periods. However, there are exceptions to this rule, partly explained by the second factor: risk. The riskier the loan, the higher the rate of interest because, for example, the lender has to be compensated for those who fail to repay the loan. Thus short-term risky and unsecured credit card loans carry much higher rates than long-term mortgage loans, secured by the value of the house being purchased. Before 2009, modern UK monetary policy operated almost solely through changes in Bank Rate. To influence the quantity of bank deposits being created (and level of AD), the BofE rationed demand for credit by raising or lowering Bank Rate. If interest rates rise, other things being equal, fewer people will want to borrow money and hence bank lending will fall and fewer bank deposits will be created. Whereas fiscal policy can affect AD by changing the level of government spending (G), monetary policy affects the other components of AD, C, I and (X-M). A fall in interest rates causes the AD curve illustrated in [Figure 8.6] to shift to the right from AD1 to AD2.
How is the Central Bank supposed to deliver Financial Stability?
Can be achieved, in part, through the central bank acting as lender of last resort to the banking system, and also, in part, by the central bank's monitoring and regulation of the financial system. The lender of last resort function is a standard function of central banks worldwide. It is commonly defined as the readiness of the central bank to extend loans to banks that are solvent but have short-term liquidity issues. By providing these funds, though at a price, the central bank aims to protect depositors and in the extreme case to prevent a systemic crisis in the financial system.
What is the Bank of England's Monetary Policy Committee?
Each month the MPC at the BofE decides the level at which the Bank Rate is set. MPC has 8 members, comprising four Bank of England 'insiders' and four 'outsiders' or external members appointed by the chancellor of the exchequer, plus the Bank's governor who exercises a casting vote on MPC decisions if the other members are split 50-50. 'Hawks' tend to resist Bank Rate cuts, and 'doves' are much more prone to cutting Bank Rate and to resisting increases in Bank Rate. The four external members are appointed for a period of 3 years, though the chancellor has the power to reappoint them. This, however, is unusual.
What are the Objectives of Monetary Policy?
For over 30 years, control of inflation has been the main objective of UK monetary policy. The gov needs to control inflation in order to create conditions in which the ultimate policy objective of improved economic welfare can be attained. The gov, in the person of the chancellor of the exchequer, sets the inflation rate target, which since 2003 has been 2% CPI inflation, and instructs the Bank of England's MPC to operate monetary policy so as the 'hit' this target. The MPC is given leeway of 1% above and below the 2% CPI inflation rate, but if the inflation rate moves outside this band of flexibility, the governor of the Bank of England must write an open letter to the Chancellor explaining why this has happened. In the 2008 recession negative economic growth and growing unemployment led to a situation in which controlling inflation as the main monetary policy was placed on the back burner temporarily, with monetary policy being used instead to try and increase AD and bring about recovery from recession. For years before this, monetary policy had been symmetrical in the sense that the BofE must stimulate AD, which will generally raise the rate of inflation, whenever inflation is expected to fall below the target rate, just as the Bank will try to increase AD to reduce inflation whenever inflation is expected to exceed the target rate. Although the Bank's primary objective is price stability, it must also support the gov's economic policy objectives, incl those for growth and employment.
How do Lower Interest Rates increase Business Investment?
Investment is the purchase of capital goods such as machines by firms. Businesses bring forward investment prokects they would have cancelled or postponed at a higher cost of borrowing, believing that new capital goods can now be profitably used. A rise in business confidence will also boost investment.
What is 'Conventional' Monetary Policy?
Involves the Bank of England raising or lowering Bank Rate so as to manage the level of AD in an attempt to control the rate of inflation.
How do Lower Interest Rates increase Net Export Demand
Lower UK interest rates lead to the selling of the pound sterling, as owners of international capital decide to hold other currencies instead. This causes the pound's exchange rate to fall, which increases the price competitiveness of UK exports in world markets. At the same time, the prices of imports rise and they become less competitive in the UK market. The UK's balance of payments on current account improves, with the increase in net export demand shifting the AD curve to the right.
What are the Main Functions of a Central Bank?
Most banks aim to make a profit, however the Bank of England is the most significant exception to this. Since its formation in 1694, The BofE acted as a private enterprise, however in 1946 it was nationalised and its surplus profit goes to the state. Two Key Functions: to help the government maintain macroeconomic stability and to bring about financial stability in the monetary system. Also carry out other related functions such as: controlling the note issue, acting as the bankers' bank, acting as the government's bank, buying and selling currencies to influence the exchange rate, and liaising with overseas central banks and international organisations. The Bank's role as banker to the gov has been significantly reduced; since May 1998 the Debt Management Office (DMO) has issued gilts on behalf of the Treasury, and in 2000 the DMO took over responsibility for issuing Treasury bills and managing the gov's short-term cash needs.
What is Monetary Policy?
Part of the economic policy that attempts to achieve the government's economic objectives using monetary instruments, such as controls over bank lending and rate of interest. Before 1997, monetary policy was implemented by the BofE on a day-to-day basis but the Bank 'consulted' with the Treasury and ultimately the Treasury had a veto over Bank rate decisions. The Treasury, which is a part of the central gov, and the Bank of England were then known as the monetary authorities. But the Treasury abandoned its hands-on role in implementing monetary policy in 1997 when the gov made the BofE operationally independent. Unless the Bank is put under pressure by the Treasury, there is now only one monetary authority: the Bank of England.
How do Time Lags effect the Transmission Mechanism of Monetary Policy?
The Bank of England estimates a time lag of up to 2 years between an initial change in Bank Rate and the resulting change in the rate of inflation. Output is affected within 1 year, but the fullest effect on inflation occurs after a lag of 2 years. In terms of the size of the effect, the Bank believes a 1% change in its official interest rate affects output by about 0.2-0.35% after about a year and inflation by around 0.2-0.4% per year after 2 years.
What is the Transmission Mechanism of Interest Rate Policy?
The BofE believes that interest rate policy affects AD and inflation through a number of channels, which form the transmission mechanism of monetary policy. The flow chart in [Figure 8.7] shows the routes through which changes in Bank Rate eventually affect inflation. Official Bank Rate decisions affect market interest rates, such as mortgage rates and bank deposit rates set by commercial banks and other financial institutions. At the same time, policy actions and announcements affect expectations about the future course of the economy and the confidence with which these expectations are held. They also affect asset prices and the exchange rate. These changes in turn affect AD in the economy. This comprises domestically generated demand and net external demand, which is determined by export and import demand. Domestic demand results from the spending, saving and investment behaviour of individuals and firms within the economy. Lower market interest rates increase domestic demand by encouraging consumption rather than saving by households and investment spending by firms. Conversely, higher market interest rates depress domestic spending. If Bank Rate falls, asset prices rise and people feel wealthier and generally more confident about the future. As a result, consumption increases. Changes in AD affect domestic inflationary pressure. An increase in AD that exceeds the economy's ability to increase the supply of output creates demand-pull inflationary pressures.
What is 'Unconventional' Monetary Policy?
The first 'unconventional' policy instrument was introduced toward the end of the recession in 2009. This was quantitative easing. In another new policy, known as forward guidance, the MPC said in August 2013 that it would leave interest rates unchanged at 0.5% until the unemployment rate had fallen to 7%, provided there weren't any risks to inflation or financial stability. When unemployment fell much more quickly than expected, the guidance was amended.
What is Funding for Lending?
The funding for lending scheme allowed banks and other lenders to borrow money cheaply from the BofE. Scheme was designed to make it easier for financial institutions to provide loans at a time when they might otherwise be reducing lending, because of their need - following the financial crisis - to shore up their battered balance sheets.
Define Bank Rate
The interest rate set by the Bank of England which it uses as a benchmark for setting the interest rates that it charges when lending to commercial banks and other financial institutions.
How does LIBOR and the Bank Rate interact?
The rate of interest at which banks lend to each other is called LIBOR, which is the acronym for the London Interbank Offered Rate of Interest. Unlike Bank Rate, which is set monthly by the Bank of England, LIBOR is determined on a daily basis by the demand and supply for funds as banks lend to each other to balance their books. Divergence between Bank Rate and LIBOR makes it difficult for the Bank of England to operate monetary policy effectively. When LIBOR is significantly above Bank Rate, a cut in Bank Rate aimed at reducing the interest rates that the general public have to pay when borrowing from high-street banks is ineffective if the rates the banks charge is determined by LIBOR rather than by the Bank Rate.
What are the Instruments of Monetary Policy?
Tools used to achieve the objectives of monetary policy. In the UK, they can involve the Bank of England taking action to influence interest rates, the supply of money and credit, and the exchange rate. There are two categories of monetary policy instrument: those that affect the general public's demand for bank loans and those that affect the retail banks' ability to supply credit and to create bank deposits. Before 2009, UK monetary policy relied almost exclusively on the use of Bank Rate, which is the Bank of England's key interest rate, to manage the demand for bank loans. In 2009, however, the Bank of England began to use quantitative easing to influence commercial banks' ability to supply new loans to their customers.
How is the Central Bank supposed to deliver Macroeconomic Stability?
With regard to macroeconomic stability, the BofEs remit is to deliver price stability and, subject to that, support the government's economic objectives including those for growth and employment. The price stability remit is defined, not in terms of zero inflation, but by the government's inflation target, currently 2% on the consumer prices index (CPI). The remit emphasises the importance of price stability in achieving macroeconomic stability, and in providing the right conditions for sustainable growth in output and employment.
