Monetary policy refers to the checking of the supply of money and interest rates by central banks to ensure stable prices and employment prevail in an economy (Melvyn, 2002). Monetary Policy entails the changes in the rates of interest to influence the growth rate and eventually the total demand, the being supplied, and eventually price inflation. Economic analysts argue that monetary policy is a more desirable way of controlling inflation compared with fiscal policy. Monetary policy too encompasses changes in the value of the exchange rate because losing the values of the currency will have far-reaching effects on the activities in an economy like the income levels, the output and prices of products. The Bank of England was given the mandate in May 1997 to manage the monetary policy in the UK. Based on the analysis of the performance of the economy by the Bank, it sets the official repo rate.
How the Bank of England Works
Assume that the Bank of England wishes to bring inflation back to the government target of 2% inflation by raising interest rates. Inflation in the UK stands at 4%. The decision of the Bank will cause the following events to take place in the economy. A rise in interest rates will make personal loans very expensive. The value of assets will decline. The wealth from the housing effect means a decline in expenditure of the wealthy class. This is likely to make firms hold fewer inventories (Patnaik, (2007). Furthermore, it leads to borrowing for investment purposes becoming very expensive. The impact of all these is a dwindling total expenditure in the economy. The effect of the Bank of England raising the interest rates to manipulate the level of expenditure of the economy, inflation is inevitable (Mark, 2008). In the USA the Federal Reserve Bank determines the interest rates at which it lends to the commercial institutions and other financial institutions. The Central Bank acts as a “commercial bankers’ bank” (Tobin, 2008). Since the Bank sets the interest rates, this interest rate, in turn, affects the interest rate that commercial banks will be charging their creditors. This implies that if commercial banks’ costs are revised upwards in terms of the interest rates, banks reciprocate by raising their lending rates as well as and become sensitive in advancing credit to their clients. The result is the customers of the respective banks reduce borrowing and expenditure. The events are likely to result from the I multiplier effect, having adverse effects on the businesses that rely on commercial loans to finance inventories; investors looking for credit facilities for shopping malls, office buildings and housing, those who want to take mortgages to purchase homes; clients and consumers purchasing automobiles and appliances; credit card holders; and local authorities financing infrastructure development (Tobin, 2008).
On the other hand lowering the interest rates discourages savings but borrowing is more desirable and spending. The impact of reduced interest rates on the consumers is a reduced amount earned from the savings and a decline in the amount paid on the loans. The reverse is true when the interest rates are revised upwards. The lowered interests are likely to raise the expectations of those in the real estate market. The exchange rate is also affected by the interest rates set by a Central Bank in an economy. The falling interest rates of the commercial banks benefit the real estate development. A rise in the rate of interest in the UK makes foreign investment in the country more desirable because investors are assured of good returns. In a nutshell, all the actions of the Bank of England can contribute to inflation in an economy (Mark, 2008).
Mark A. (2008). How Monetary Policy Works. Web.
Melvyn K, (2002). Monetary policy. An introduction to macroeconomics. Web.
Patnaik, I,. (2007). Monetary Policy in India. Web.
Tobin, J,. (2008). The concise encyclopedia of economics Monetary Policy. Web.