The nature of monetary policy and the interest rate instrument

Overview

Monetary policy, policy rate and inflation target symmetric rather than simply a ceiling.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is monetary policy?

   Model answer

   Monetary policy is the management of interest rates and the supply of money and credit in order to influence the level of demand in the economy, usually with the aim of keeping inflation low and stable. In practice the central instrument is the official short-term interest rate set by the central bank, which feeds through to the rates households and firms actually face. It is a demand-side policy, because it works by changing how much people choose to borrow, spend and save.

2. 2

   What is the policy rate, sometimes called Bank Rate, and why does it matter so much?

   Model answer

   The policy rate is the rate the central bank sets for its own dealings with commercial banks — the rate at which it lends to them and pays on the reserves they hold with it. It matters because it anchors the whole structure of interest rates: commercial banks price their lending and savings products in relation to it, so a change passes through to mortgages, business loans and deposit rates, and from there to consumption, investment, the exchange rate and ultimately the price level.

3. 3

   Who sets monetary policy in the United Kingdom, and why is the decision taken by an independent committee rather than by ministers?

   Model answer

   It is set by the Monetary Policy Committee of the Bank of England, which meets regularly and votes on the level of Bank Rate. Independence exists because politicians face an incentive to keep rates low before an election, and if households and firms expect that, they build higher inflation into wage claims and price setting. A committee that is insulated from that pressure and judged against a published target is more credible, so expectations of inflation stay anchored and the interest rate needed to control inflation is lower.

4. 4

   What target does a central bank such as the Bank of England pursue, and how is it defined?

   Model answer

   It pursues a numerical inflation target, in the United Kingdom set at 2% measured by the annual change in the consumer prices index. The target is symmetric, so the central bank is required to respond to inflation that is too low as well as to inflation that is too high. Subject to meeting the target, it is also expected to support the government’s objectives for growth and employment, which is why decisions involve judgement about how quickly to bring inflation back.

5. 5

   Why is an inflation target symmetric rather than simply a ceiling?

   Model answer

   Inflation that is persistently below target is itself damaging, because households may delay purchases in the expectation of lower prices later, the real burden of existing debts rises, and firms find it harder to cut real wages when the labour market needs adjusting. Very low inflation also leaves the central bank little room to cut real interest rates in the next downturn. A symmetric target therefore commits the central bank to loosen policy when inflation falls too far as well as to tighten when it rises too far.

6. 6

   What is the difference between loose and tight monetary policy?

   Model answer

   Loose or expansionary monetary policy means cutting interest rates, and possibly expanding the money supply, so that borrowing becomes cheaper, saving becomes less rewarding, and aggregate demand rises. Tight or contractionary policy means raising interest rates and restricting credit so that borrowing becomes dearer, saving more attractive, and aggregate demand falls. A central bank loosens to fight weak demand and rising unemployment and tightens to fight demand-pull inflation.

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