Use Of Monetary Policies To Achieve Price Stability In The UK.

Examine the use of monetary policies to achieve price stability in the UK Price stability is achieving low inflation, in the UK the target for inflation is 2% of CPI (+/- 1% i.e. 1-3%). This target is set by the Monetary Policy Committee (MPC), which is affiliated to the Bank of England, and so is a non-governmental organisation since 1997. Inflation means persistence rise in average general price level and there are two types/causes of inflation, one being demand-pull and the other cost-push. MPC can manipulate interest rate, exchange rate and money supply (Q.E.) to achieve low inflation and price stability. Firstly, if there is demand pull inflation i.e. price level is rising due to excessive AD, one way is by raising the interest rate. Interest rate is cost of borrowing and reward for saving. By doing so, the cost of borrowing becomes high, hence decreasing consumption by households and Investment by firms as these are components of aggregate demand, therefore AD will shift to the left. Also, as high interest rate will have the more reward for saving, again consumption likely to decreases and so does aggregate demand as a result of it. Furthermore, as investment and consumption have a positive relationship, investment will also decrease. Lower AD is likely to bring the high inflation the target of 1-3%, however growth rate is likely to decrease too at the same time. (Draw diagram shifting AD shifting left) However, it depends on the magnitude of the change. As base rate is only changed in quarters (0.25, 0.5, 0.75 or 1% ...) if interest rate is only lowered by 0.25% it may not have a significant effect on consumption or investment as it affect the cost of borrowing by much at all. Also, if the consumers and firms had a fixed loan the change in interest rate wouldn't affect them at all as their repayment would not change with the change in the variable rate of interest rate. Secondly, if there is cost push inflation i.e. price level is rising due to too high cost of production and lower AS, MPC likely to lower the base rate to control inflation. By using expansionary/loose monetary policy, MPC would like to encourage investment as it will be cheaper to invest for firms as taking loan at lower rate means less repayments and less cost of production, which will leave more funds available for Examine the use of monetary policies to achieve price stability in the UK. investment. Thus increasing aggregate demand and aggregate supply, as investment is a component of both. Also, more investment in capital stock means LRAS will increase to accommodate excess demand hence less pressure on price level and likely to keep the rate of inflation low. However, the change in base rate does not guarantee that the commercial banks like Lloyds and HSBC etc, will pass it further. The desired effects of the change in interest rate can take 18-24 months and mainly the effects depends upon the confidence levels, as if they are still not happy to invest, perhaps due to recession or negative wealth effect, lowering interest rate will have very limited effect. Moreover if there is deflation i.e. price level is decreasing, by decreasing the interest rate the exchange rate also likely to decrease as there is a positive relationship between the two. If there is lower interest rate, this causes less demand for the pound as less FDI and Hot Money due to less expected rate of return, hence lower value of the pound likely to increase international competitiveness, and so increasing exports. As exports are an injection, whereas, imports are a leakage this will result in the positive multiplier effect taking place. Overall, this will increases aggregate demand as exports are a component of aggregate demand. AD likely to rise so does PL and inflation likely to come back to the MPC's target. However, a change in interest rate may not change the value of currency if the demand for hot money and FDI does not change due to other factors such as corruption, political instability or higher COP or regulation etc. Also, despite the lower value of pound, the exports may not increase if the non price factors such as quality and innovation are not meeting the market trends and demand. Lastly, if the interest rate is extremely low like at present base rate is 0.5% and the price level is still decreasing and there is fear of deflation, to combat deflation the bank of England can decide to use a non-tradition method i.e. Quantitative Easing i.e. increase the money supply in the circular flow of income. Quantitative easing is not printing new money, it is an electronic transfer of funds from Examine the use of monetary policies to achieve price stability in the UK. central bank to commercial banks and central bank buys off the assets and bonds of the commercial banks in return. This results in improvement in liquidity and banks being able to lend further as more money is being pumped into the banking system. By increasing the money supply, hence increasing lending, consumers will have more money to buy household goods and services and firms would have more access to credit to invest more hence increasing aggregate demand as a final result. Finally, it should help central banks to achieve inflation target and price stability. However, in 2009 when UK used QE for the first time did not improve the liquidity due to credit crunch i.e. banks were very reluctant to lend, despite being given more money to lend further. This therefore led to not achieving MPC'S intentions to achieve inflation target. In conclusion, the change in MPC's policies likely to achieve price stability within 18-24 months provide the other policies such as fiscal taxation and government spending are not conflicting. In short, loose monetary policy may not be able to achieve the target if tight fiscal policy is neutralise the effects.