Problem Focused Exercise: Monetary Policy- how is it decided?
1
The Scenario
The Monetary Policy Committee sets the interest rate each month in the UK.
We explore how monetary policy affects the economy and the factors that
are important in determining the Committee’s decision.
Task A
Read the short extract How Monetary Policy Works from the Bank of
England’s website on the next page. From the article identify the following
outcomes of a reduction in interest rates.
(1) How does a reduction in interest rates affect a sequence of other
things? Identify the direction of the changes in your answer.
(2) What economic objectives do interest rates affect?
(3) How do the effects need to be aggregated to consider the effect on
the economy? What economic model (and associated diagram) is
appropriate to use in such an analysis?
Write your answer either hard copy or in your own word
processing file in order to compare to our feedback.
Continued on the next page
Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for
Employment and Learning (DEL) under the Fund for the Development of Teaching and Learning.
Problem Focused Exercise: Monetary Policy- how is it decided?
How Monetary Policy Works
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2
From interest rates to inflation
A reduction in interest rates makes saving less attractive and borrowing more
attractive, which stimulates spending. Lower interest rates can affect
consumers’ and firms’ cash-flow – a fall in interest rates reduces the income
from savings and the interest payments due on loans. Borrowers tend to spend
more of any extra money they have than lenders, so the net effect of lower
interest rates through this cash-flow channel is to encourage higher spending in
aggregate. The opposite occurs when interest rates are increased.
Lower interest rates can boost the prices of assets such as shares and houses.
Higher house prices enable existing home owners to extend their mortgages in
order to finance higher consumption. Higher share prices raise households’
wealth and can increase their willingness to spend.
Changes in interest rates can also affect the exchange rate. An unexpected
rise in the rate of interest in the UK relative to overseas would give investors a
higher return on UK assets relative to their foreign-currency equivalents, tending
to make sterling assets more attractive. That should raise the value of sterling,
reduce the price of imports, and reduce demand for UK goods and services
abroad. However, the impact of interest rates on the exchange rate is,
unfortunately, seldom that predictable.
Changes in spending feed through into output and, in turn, into employment.
That can affect wage costs by changing the relative balance of demand and
supply for workers. But it also influences wage bargainers’ expectations of
inflation – an important consideration for the eventual settlement. The impact
on output and wages feeds through to producers’ costs and prices, and
eventually consumer prices.
http://www.bankofengland.co.uk/monetarypolicy/how.htm
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Copyright: Embedding Threshold Concepts Project
26/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment
and Learning (DEL) under the Fund for the Development of Teaching and Learning.