Real Interest Rate
Real interest rate refers to the interest rate that a lender, a saver or an investor receives or expects to obtain after considering inflation. It is often described using the Fisher equation that asserts that real interest rate can be approximated by deducting the inflation rate from the nominal rate of interest. As such, it includes all the risks that may be involved in the measurement of the time value for money. When we talk of nominal interest rates, we imply the interest rates that have all the three main risks and the time value of money included. In economics, real interest rate is often regarded as the rate of return on an investment that is free from risk. For instance, notes that are issues by the treasury without the inflation index.
MPC Evaluation in Controlling UK's Inflation Rate since 2011
The MPC has been successful in inflation rates control in the UK since the year 2011. As stated by one of the senior policy makers the monetary policy committee is only prepared to increase interest rates in the future if the inflation rate continues on an upward trajectory. The MPC states borrowing cost can only go up if household debt will go up and reach unhealthy levels. That remains the thinking of the MPC but has not taken any action for the time being it isn’t required there being no threat to the economy meaning the committee has worked to ensure inflation remains stable since 2011. The UK base rate is currently at 0.5%, the inflation is currently low and even expected to be negative. (Andrade, Galí, Lebihan and Matheron 2018)This means the MPC is under no pressure to address issues of inflation though they remain cautious in case any scenario presents that need attention.
MPC's Role in Controlling Inflation
The following diagram illustrates how inflation has been contained since 2007 up to 2011, which is an evaluation of Monetary Policy Committee in controlling inflation. MPC has the sole responsibility and mandate to set interest rates and determine UK monetary policy. They have a duty to ensure the inflation rate remains close to CPI 2% +-1 %, which is the government target. From the presentation, is clear the inflation rate has remained relatively stable.
Advantages of MPC Setting Interest Rates
The reason inflation has remain low is also compounded by the fact that MPC sets the interest rates. There are advantages in MPC setting interest rates that include the following:-
Independence- MPC is not under influence of politicians and is not subject to political pressures.
The policy is pre-emptive-they try the best to control inflation before occurrence by predicting future trends on inflation.
MPC reduces inflation expectations by ensuring people remain confidence that inflation will be low in the future.
They ignore aspects that have no much influence on inflation like money supply by targeting inflation directly.
Maintained inflation at 2%, which is the government target since 1997 unlike 10% jump, experienced in 1980s.
Consumer spending is influenced by interest rates, which are under the control of MPC.
The Risk of Deflation in the UK Economy
Monetary Policy Committee should not worry much about deflation. Though when prices of goods such as electronics and clothes keep falling, people carry on to buy. Even when price of food commodities fall sharply people will still buy. Deflation will only be an economic issue of concern for the monetary policy committee if it affects long-term assets. It will also be an issue of concern if developed into expectations. For example, a negative Consumer Price Index (CPI) such as one disturbed by temporary Value added tax cut would be a concern for MPC on deflation. Therefore, MPC ought not to worry about deflation since ordinary consumers will still purchase commodities even if prices fall and that maintain price expectations in the economy. However, earlier in a deflationary spiral the MPC will be concerned since they may not know what it presents to the economy.( Cowling, Liu, Ledger and Zhang 2015). They will have to take big risk especially on monetary and fiscal policy to ensure it is prevent from spiraling.
Demand Side Policy to the Global Financial Crisis of 2018
The global financial crisis or recession occurs when Gross Domestic Product or GDP declines for two successive quarters. Because of the dip, stock market is affected; there is increased unemployment and decline in the housing market. Generally, the quality of life for the citizens in a nation is greatly affected since most people cannot afford to survive and if they survive, they do so on very less income. Some of the demand side policy responses to global financial crisis of 2008 were implementation of fiscal policy with an economic stimulus act of 2008. The stimulus package introduced tax rebates of $1200 per family. The government also introduced business incentive tax credits to infuse much money into the economy and therefore entice consumers to use more money in expenditures. The stimulus package also ensured an increase for loan limits on mortgages in high-end places or suburbs. Another demand side policy was increase in expenditures for the governments by increasing funding on crucial programs such as unemployment as well as introduction of tax credits to businesses and working households. There was also implementation of Monetary Policy to curb the steep decline in the economy with interest rates being lowered to 0%. (Goh, Li, Ng and Yong 2015)The Federal Reserve had to implement a quantitative easing by purchasing assets like banks in cash and thus stimulate greater money supply in the economy. Federal Reserve also purchased government bonds from individuals in cash and therefore increased money in circulation.
Effect of a Rise in the Value of a Pound on Aggregate Demand
There are likely effects of a rise in the value of the pound on aggregate demand. Some of the effects are that exports will become more expensive. The foreign price of exports from the UK increases and therefore other European countries find exports from Britain very expensive. Higher price means a fall in quantity of exports from the UK. Rise in value of pound means that imports will be cheaper. Consumers in the UK find that a dollar can now buy greater quantity of goods from Europe. When imports become cheaper, there is greater increase in imports in terms of quantity. There is also lower export demand and increased spending on imports, which leads to fall in Domestic Aggregate Demand resulting in slow economic growth.(Al Mahubi 2018) Rise in value of pound also leads to lower inflation. This is attributed to cheap prices for imports, cost of imported goods fall after appreciation of the pound. Lower aggregate demand can significantly lead to lower demand-pull inflation. Finally, with more expensive export prices, manufacturers will have the desire for implementing cost cuts in an effort to remain competitive and more relevant in the market.
Conclusion
Monetary Policy Committee plays a critical role in the UK economy. It has been able to control inflation over a long period, maintaining it within the government’s target of 2% since 2007. Inflation is mostly influenced by the interest rates offered by commercial banks but worthy noting is that the central bank through the Monetary Policy Committee has maintained a base rate of 0.5 %. This has the effect of ensuring loans and credit advanced to consumers is at a lower rate. MPC has fewer concerns on the issue of deflation.(Afonse and Jalles 2016) Ordinary consumers are not affected by fall in prices of commodities such as food and electronics. They will continue to purchase them oblivious of the changes in price. The global crisis of 2008 was a wake-up call to nations to implement demand side policies early enough to mitigate instances of such occurrences. The effects felt then were far reaching with interest rates lowered to 0% to increase circulation of money in the economy. However, governments and central banks were quick enough to implement policies that forestall confidence in the economies and ensured the crisis was neutralized in a short time.
Maintaining a balance between exports and imports is important for business and general well-being of a nation. When prices are distorted due to appreciation or depreciation of a currency the effects are on importers and exporters of commodities since prices will also change affecting even the producers some who remain at the base of the value chain. Change in prices also affects employment since many workers in export and import sector will feel threatened by the changes felt through currency valuation or devaluation.
References
Andrade, P., Galí, J., Lebihan, H. and Matheron, J., 2018. DP12723 The Optimal Inflation Target and the Natural Rate of Interest.
Al-Marhubi, F., 2018. Political Capacity and Economic Determinants of Inflation. In Political Capacity And Economic Behavior (pp. 67-77). Routledge.
Cowling, M., Liu, W., Ledger, A. and Zhang, N., 2015. What really happens to small and medium-sized enterprises in a global economic recession? UK evidence on sales and job dynamics. International Small Business Journal, 33(5), pp.488-513.
Afonso, A. and Jalles, J.T., 2016. The fiscal consequences of deflation: evidence from the golden age of globalization.
Goh, B.W., Li, D., Ng, J. and Yong, K.O., 2015. Market pricing of banks’ fair value assets reported under SFAS 157 since the 2008 financial crisis. Journal of Accounting and Public Policy, 34(2), pp.129-145.
