The Monetary Policy Committee (MPC) of the Bank of England has not been successful in maintaining inflation. Monetary policy refers to the use of interest rates and other tools to affect consumer spending and aggregate demand in the economy (Boneva, Weale and Wieladek 2016). Some of the monetary tools used are; open market operations, moral suasion, discount rates and minimum reserve requirement. The main aim of monetary policy is to avoid recessions, stabilize the economy and maintain low levels of inflation rate. In the United Kingdom, the government sets the inflation target. The set level is 2.5% but the target is 2%.
Aggregate Demand and Supply Curve
The graph above shows the aggregate demand and supply curve. If the inflation target is below 2%, the Bank of England cuts the bank rate which lowers the interest rate. Access to credit is increased which stimulates consumer spending increasing the aggregate demand from AD1 to AD2. However, if it feels that inflation target is high, it increases the bank rate which increases the interest rates. Therefore, the economy slows down and access to credit is limited. As such, consumer spending is reduced.
The reason the MPC has not been effective is due to the European financial crisis of 2008 which had devastating effects on the economy. There was a reduction in the prices of energy and non-energy items such as telecommunications. There was a drop in the cost of shipping goods. As at 2015, the deflation rate was 0.5%. Brexit adversely affected the United Kingdom economy by lowering the forecasts from 2.6% to 0.4% in 2017. The rate also dropped from 2.4% to 1.4% in 2018. The Bank of England governor, Mark Comey raised the capital requirement of the largest banks by 10 times. As a result, the amount was raised to £ 600 billion. Therefore, these events made it hard for the MPC to control inflation in the UK due to external forces.
Time Lags. If the Bank of England lowers the base rate from 0.5% to 0.3%, it will take a longer time for the effects to be felt in the economy. For instance, if an individual has a three year fixed mortgage, he/she will not feel the effect unless they remortgage (Hanson and Stein 2015, p. 430). Therefore, the bank should forecast the future inflation rate so that it can change the interest rate in expectation.
The changes in the interest rates affect some sectors of the economy more compared to others. For instance, with the recent increase in interest rates, the prices of houses are still rising. For many people with small mortgages, the changes have a very little effect. However, the rise is a disadvantage to new entrants in mortgages and real estate. It can increase the purchasing power of the consumers with savings and make it difficult for people who are paying mortgages.
Monetary policy in the form of interest alone is not sufficient to control the entire economy. For instance, an increase in prices of oil globally can cause inflation leading to low growth rate. In turn, a bank can raise the interest rates to control inflation. However, this will slow down economic growth. For example, in 2009, global prices of oil increased leading to inflation and the economy was still in a recession. The Bank of England allowed a temporary inflation for the economy to "cool".
Lastly, it is the liquidity trap. It refers to a situation where the Bank of England can lower the bank rates but commercial banks do not lower their interest rates to pass the benefit to the borrower. As such, the borrowers are discouraged to borrow because the rates are still high. Access to credit is limited. It may also be a situation where the interest rates are low but consumers are not borrowing due to low confidence in the banks and economy.
Question Three
Deflation is the consistent decrease in prices of commodities over a given period of time. The Monetary Policy Committee should be concerned about deflation. In case of a deflation, consumer expenditure decreases which lowers the aggregate demand (Davis 2015, p.106). If the aggregate demand shifts to the left from AD2 to AD1, the economy is likely to create deflationary pressure in the economy.
Deflation has the effect of increasing the value of money. As such, it increases the real value of debt. If a country is repaying a debt, it spends a bigger percentage of its revenue paying debts. Firms earn low revenues and consumers get low wages (Warren 2015, p. 950). Therefore, the savings and investment are low which leads to balance sheet recession where both the firm and consumers reduce their debt exposure.
However, deflation is not necessarily bad. It increases the value of money which means that consumers can be able to purchase more with a given amount of money compared to what they were buying previously. The creditors gain because they get more in terms of the real value for money (Lin, Tsomocos and Vardoulakis 2015, p.90). The cost of education, healthcare, housing, and amenities are lowered which reduces the cost of living.
Question Four
Demand-side policies refer to the use of fiscal and monetary policies to influence the aggregate demand in the economy to stabilize employment and price levels (Singh, Doolla and Banerjee 2017).
During the global financial crisis of 2008, the United Kingdom employed a number of demand-side policies to stimulate the economy. Some of the fiscal policies adopted were the reduction of Value Added Tax (VAT), increase in government expenditure to expand infrastructure in the education, health and construction industries, investment in green energy and a training budget for the employed. However, in 2010, it adopted measures which were aimed at reducing the budget deficit
In the United Kingdom, the Monetary Policy Committee (MPC) reduced the base interest rate in phases from 5.75 % in 2007 to 0.5% in 2009. There was a dire need to use a different monetary tool to revive economic growth. The Bank of England adopted quantitative easing. In 2014, it spent £375 billion on the programme. It involves printing more money digitally to purchase assets such as bonds from institutional firms such as pension funds. It has the effect of increasing the aggregate demand reviving economic growth. The disposable income of the consumers increases due to access to credit. Therefore, the aggregate demand shifts from AD1 to AD2 increasing economic growth, output and production.
In 2009, the Bank of England suggested the first phase of quantitative easing of £ 200 billion to help increase economic output by between 1.5 –2 %. However, critics argue that lending to consumers and firms lead to economic slowdown because institutions hoard the surplus ‘cash’.
Works Cited
Boneva, L., Cloyne, J., Weale, M. and Wieladek, T., 2016. External MPC Unit Discussion Paper No. 47 The effect of unconventional monetary policy on inflation expectations: evidence from firms in the United Kingdom.
Davis, J.S., 2015. The asymmetric effects of deflation on consumption spending: Evidence from the great depression. Economics Letters, 130, pp.105-108.
Hanson, S.G., and Stein, J.C., 2015. Monetary policy and long-term real rates. Journal of Financial Economics, 115(3), pp.429-448.
Lin, L., Tsomocos, D.P. and Vardoulakis, A.P., 2015. Debt deflation effects of monetary policy. Journal of Financial Stability, 21, pp.81-94.
Singh, E.P., Doolla, S. and Banerjee, R., 2017. Demand Side Management.
Warren, P., 2014. A review of demand-side management policy in the UK. Renewable and Sustainable Energy Reviews, 29, pp.941-951.
