Monetary Policy, Put Simply

Economics terms are thrown about by those in-the-know all too regularly. Frankly, its baffling for those of us without expert knowledge in the subject, and “put simply” explanations are infrequent to say the least. #LetsTalkPolitics and challenge this.

The government, and even more specifically the Bank of England have a variety of techniques to deliberately affect the UK economy and its subsequent activity. The three main techniques used are Monetary policy, Fiscal Policy and Supply side policy, each having different impacts as well as different durations of effect over time.

Monetary policy is a direct mechanism for altering aggregate demand and UK economic activity. The Monetary policy Committee (MPC), a select group of nine members, four of whom are chosen by the Chancellor himself, are all appointed to reach the target of 2% inflation (a sustained increase in the average price level) for the country. They can do this through either altering the ‘base’ interest rate (the reward for lending and cost for borrowing) which sets the interest rate for all banks in the United Kingdom, or they can directly effect activity through increasing or decreasing the supply of money in an economy (Quantitative Easing).

If the MPC sets the interest rate relatively high then this spreads to commercial banks and building societies that typically follow shortly after. These banks then increase how much they charge for consumers to take out loans and increase the interest that they offer on savings held within the bank. Therefore this discourages businesses and consumers from taking out loans for investment as the cost is increased. Furthermore it encourages consumers to save, ultimately decreasing aggregate demand overall. This can ease inflationary pressures in the economy, in occasions such as an economic boom.

Comparatively when the MPC lowers the rate, the opposite occurs. Businesses and consumers tend to gain more loans and increase investment and subsequent aggregate demand overall.

A change in interest rates can also affect the exchange rate of the economy. An increase will lead to an appreciation in the exchange rate compared to other economies. Therefore the (Sterling £) will rise leading to cheaper imports and more expensive exports overall. This leads to less spending in the UK economy and hence eases inflationary pressures. On the other hand if deflationary pressures are in hand, then the decrease in interest rates and subsequent depreciation of the exchange rate can lead to the (Sterling £) falling against other currencies. This leads to our goods and services being more appealing to other economies, hence more are bought, and aggregate demand increases.

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