Suppose the central bank fears that inflation raises a result of economy boom. It decides tom take action to decrease aggregate demand and spending. So, it would raise interest rates and discourage borrowing and expenditure on good and services. What does the central bank change the interest rate? Figure 1 below shows how the Bank of England determined the interest rates with reference to economy theories. We draw the money demand schedule LL for a given level of real income. If the Bank can fix the real money supply, then for a given level of good prices, it can fix the real money supply at L0 provides whatever money is demanded and the equilibrium interest rate will be r0. Alternatively, the central bank can fix the interest rate at r0 and supply whatever money is needed to clear the market at this interest rate. In equilibrium, the central bank supplies exactly the quantity of money demanded at the interest rate r0. The money supply is still L0. The central bank can fix the money supply and accept the equilibrium interest rate implied by the money demand equation, or conversely, like what Central banks is doing now, fix the interest rate and accept the equilibrium money supply implied by the money demand equation. When the interest rate starts to fall below the level r0, either because of too little demand for money or too much supply, the Bank reduces the monetary base, through an open market operation, until the interest rate is r0 again. Conversely, when the interest rate exceeds r0, the Bank simply increases the monetary base until the interest rate falls to r0.To control the money supply by using interest rates, the Bank must know the position of the demand schedule. Fixing the interest rate r1, the resulting money supply will be L1 if the demand schedule is LL but will be L’1 if the demand schedule is LL’.
Figure 1. Interest rates and monetary control, the graph shows how the equilibrium interest rate have made depending on the amount of money the Central Bank supply and the money demand schedule LL.
L1 L1’ L0
Real Money Holding
(Cited from D. Begg, S. Fischer & R. Dornbusch Economics)
Similar theories below that involved number are explanting how the interest changes which different factors. Suppose the central bank undertakes open market operations and need to decrease the money supply from £300 billion to £290 billion. As a result, the supply curve of real money will shift from MSo to MS1 as shown in figure 2. The demand curve MD shown the amount of money businesses plan to hold at each interest rate. While the interest rate is 5 per cent and money supply as £290 billion, businesses are holding less money and they attempt to increase their money by selling bonds or stocks etc. Therefore the price of bonds and stocks fall and interest rate rises. As shown in the figure, interest rate will increase to 6 per cent and proplr are happy to hold £290 billion stock of money. Conversely, suppose the Bank sale the securities to increase real money supply to £310 billion. The supply curve will shift from MS0 to MS2. With excess supply of money, people are willing to use the excess to buy the financial assets. Therefore, the prices of the assets rise and interest rate fall. Equilibrium occurs when interest rate is at 4% and the business are willing to hold money stock of £310billion.
Figure 2. An open market sale of securities shifts the money supply from MS0 to MS1 and the interest rate rises to 6%. An open market purchase of securities shift money supply from MS0 to MS2 and interest rate fall to 4 per cent.
MS1 MS0 MS2
0 280 290 300 310 320
Real money supply
(Cited from M. Parkin, M. Powell & K. Matthews, Economics)
Nevertheless, there are numbers of factors that the MPC need to take into account before changing the interest rates. Small firms are often affected greatly by changes in interest rates as they have smaller financial reserves and a relatively greater need for borrowing. The Bank of England estimates that every 1% rise in interest rates costs the UK’s 1.5m small firms an extra £200m in interest rate payments. Significant rises in interest rates can lead to substantial increases in bankruptcies amongst small firms. Even larger firms with high levels of borrowing can be affected by changing in interest rates. For example, a rise in rates can lead to a hefty increase in payments forcing firms to reduce costs elsewhere or to pass on the extra expenses in the form of higher prices – if this is possible. Alternatively a cut in interest rates offers reduction in expenses to such firms improving their competitiveness. However, it is not only the direct effects of changing the interest rates that affect businesses. The use of interest rate policy by the authorities can have a profound impact upon the general economic environment in which businesses operate. The MPC changes interest rates to assist the government in achieving its economic objectives. This means that changing rates affects the level of unemployment, inflation and growth existing in the economy. They also change managers’ expectations of these key economic variables affecting their day- to- day and strategic decisions.
To be concluded, the Bank of England’s Monetary Policy Committee has been accused of being ‘trigger happy’ and changing interest rates too readily. It changed the base rate 15 times in the first 28 months of its existence. But in recent few years, the Bank of England held interest rates steady at 6% in December 2000 for the tenth time in a row, making the longest period of stable borrowing rates since the 1980s. This follows a period in which the bank was criticized for changing rate too regularly.
The changing of interest rates takes up to two years to have its impact on the economy. Therefore, the MPC has to forecast the trend of prices at least two years into the future. Overall, most people are satisfied with the MPC performance so far. It may raise interest rates even current inflation is under control, and inflation has remained close to 2.5 per cent. Since inflation expectations are low, nominal interest rates are low as well.
References
1. R. Lipsey & K.A. Chrystal, Principles of Economics, 10th edition, O.U.P.
2. M. Parkin, M. Powell & K. Matthews, Economics, 5th edition, Addison-Wesley.
3. John Soloman, Economics, 4th edition, Pearson.
4. J. Beardshaw, D. Brewster, P. Cormack & A. Ross, Economics: A student’s Guide, 5TH edition, Pearson.
5. D. Begg, S. Fischer & R. Dornbusch, Economics, 7th edition, McGraw-Hill.
