Monetary Policy
Are interest rates the principal channel by which monetary policy affects economic activity? To answer to this question first of all we need to know what is the main core of monetary policy. And it is the bank that controls money supply, interest rate and other banks. It is central bank like in our case we are talking about Bank of England. "The Bank's roles and functions have evolved and changed over its three-hundred year history. Since its foundation, it has been the Government's banker and, since the late 18th century, it has been banker to the banking system more generally - the bankers' bank. As well as providing banking services to its customers, the Bank of England manages the UK's foreign exchange and gold reserves. The Bank has two core purposes - monetary stability and financial stability. The Bank is perhaps most visible to the general public through its banknotes and, more recently, its interest rate decisions. The Bank has had a monopoly on the issue of banknotes in England and Wales since the early 20th century. But it is only since 1997 that the Bank has had statutory responsibility for setting the UK's official interest rate."(http://www.bankofengland.co.uk/about/more_about.htm)
As it is already mentioned Bank of England has two cores and one of them is monetary policy. This part of Bank is responsible for monetary stability and it controls money supply. It can be done in three main ways:
. By controlling the reserve ratio (rb). Bank of England (Central Bank) can determine the percentage of banks' deposits that is held in form of currency reserves.
Commercial banks are profit maximising, deposit taking institutions. In order earn profit they use deposits that they take from one part costumers for investment and lending to other part of costumers. For maximising profit banks are lending at a higher rate of interest than they are paying to depositors. However they can not use all deposits for investments and lending. As it is written before the Bank of England determines the percentage of deposits that banks have to hold in form of currency reserves. At the moment the ratio is 2% of all bank deposits. That means that if bank has £100k deposits it has to keep at least £2000 in form of currency as reserve. The money multiplier is equal:
mm - money multiplier
rb - currency reserve deposit ratio
Now to show how it influences money supply I will make the following assumptions:
(i) Banks must hold currency reserves (Rb) in proportions, at least as big as Central Bank determines, to banks deposits (D).
(ii) The private sector wishes to keep currency to the value (Cp) in proportions (c) to banks deposits (D).
(iii) High powered money (H) is the currency issued by Central Bank. It is currency hold by private sector plus currency banks reserves.
So, from that we can ...
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mm - money multiplier
rb - currency reserve deposit ratio
Now to show how it influences money supply I will make the following assumptions:
(i) Banks must hold currency reserves (Rb) in proportions, at least as big as Central Bank determines, to banks deposits (D).
(ii) The private sector wishes to keep currency to the value (Cp) in proportions (c) to banks deposits (D).
(iii) High powered money (H) is the currency issued by Central Bank. It is currency hold by private sector plus currency banks reserves.
So, from that we can get that:
(iv) The money supply is equal to all money in circulation that means currency hold by private sector and bank deposits.
In this case:
So, now we can see:
That is how money multiplier can influence money supply, and how Bank of England can control it by changing reserve ratio.
2. By using open market operation: it can control how currency reserves are distributed between its own holdings and the private sector. It is done by selling and buying government stock. This is called monetary base control because the currency issue is the base on which money supply is built.
Central Bank sells stock in open market for individuals and they pay for stock by cheque drowns on their account. Than Bank of England takes these cheques to commercial banks, and now commercial banks owe the Central Bank amount of money equal to the value of cheques. Commercial banks can settle their debt to Bank only by transferring currency, so they must take that amount of money from their reserves and this means that now banks has smaller reserves than they need, so they have to reduce investment and loans to get back to the reserve ratio. It means that now there is less money in circulation and it leads to smaller money supply. The opposite happens if Central Bank buys stock from individuals.
3. By changing interest rates of borrowing. Bank of England being the lender of the last resort can control borrowing interest rates. If Bank increases rates it becomes more expensive to borrow from it to financial institutions and they are raising their own interest rates, decreasing rates leads to decrease in financial institution interest rates. It has been estimated that 1% increase in interest rates will lead to £10 billion fall in output per annum.
There are two ways of increasing interest rates:
(1) The Bank of England can change it by open market operations. If Bank wants to increase interest rates and there is no shortage of money in the economy Central Bank can reduce supply of money by selling bonds this will decrease amount of money in the economy and it will lead to increase in interest rates.
(2) Theoretically, Bank can change interest rates by buying or selling government securities.
Now let's have a look what possible effects has increase in interest rates:
(1) It leads banks to increase the size of their reserve deposit ratios, because with higher interest rates it is more expensive to borrow from Central Bank. This will reduce money multiplier and it will lead to decrease in money supply.
(2) Increasing in interest rates is increasing in borrowing price. So, there will be les borrowing and consumption expenditure will fall.
(3) Reduce the present value of expected net revenues. This will lead to decrease in investment and borrowing.
(4) Overdraft rates increases, so, costs of production go up.
(5) Higher costs of production lead to bigger prices and demand decreases.
(6) Lead the banking system to review its future projections. It can change the lending for any risk level projects. If banks think that economy is going to decline they are willing to invest in less risky projects. This reduce in lending can lead in a very large fall in economic activity - a 'credit crunch'.
(7) Bring about an increase in the nominal and real exchange rate.
Now let's have a look if Bank of England can influence the GDP. Lets assume that economy is in initial equilibrium position E, which is intersection of LM(M0/P0) and IS(G0,M0/P0) curves, you can see it in Graph 1. Now assume that Central bank increases money supply from M0 to M1 so LM curve shift to the left. So, interest rates go up from r0 to r01. This means that there is an excess demand for money, it would influence inflation. So, Bank of England will sell pound for overseas individuals for it Central bank will get abroad currencies. The pounds received by overseas individuals will enter UK economy. It will increase money supply. And will continue until economy comes back to initial equilibrium position E. This can increase GDP. However, monetary policy is ineffective when exchange rates are fixed. Than Bank of England can not influence GDP.
Graph 1
So as we see one of the ways that Bank of England is controlling money supply and affecting economy is change of interest rate. Changing interest rate is one of most effective ways to stabilise economy. We can easily prove it by looking to the last recession and looking back to UK history.
1980s and 1990s the years when UK had two highest interest rates in its history: 17% in 1980s and 15% in 1990s.after both of these years there was e recession following our economy. In both times the interest rates were increased to keep the stability of economy and to reduce inflationary pressure. In 1990, interest rates were also increased to protect the value of the Pound Sterling in the Exchange Rate mechanism. However, after both tries there was e recession following. And in the recession there is only one way to stabilise economy to reduce interest rates. After UK left the ERM in 1992, the Government were able to cut interest rates and after that the interest rate were kept lower and more steady.
But as we are witnessing now it was not all. The interest rate were more steady than before but the housing prices were growing enormously and this was meant to lead us to one more recession. And this time international and very long one. Moreover nobody knows when it will end. However, as we saw before we can witness again that to stabilise economy and start it growing the monetary policies are using reduction in interest rate. And this time it reached the lowest point it's ever been 0.5%. Moreover it is predicted to stay in its bottom during 2010. The factors that are keeping it down are:
o Depth of recession and scale of fall in GDP
o Predicted rise in UK unemployment close to 3 million
o Budget Deficit rising to 12% of GDP means the government is under pressure to improve fiscal position. This will require higher taxes and lower spending. This fiscal stance could damage recovery and is deflationary. Therefore if taxes rise, it is more likely interest rates will stay low.
o Inflation predicted to fall below the government's target of 2% and stay close to 1%. With falling oil prices, deep recession and high levels of spare capacity, inflation is forecast to remain low in 2009. It is expected inflation will fall to below the government's target of 1%. This raises the ugly potential of deflation - something the MPC will be very keen to avoid. The RPI measure of inflation shows a high level of deflation -1.2% (RPI measure includes mortgage interest payments)
o Given this gloomy outlook for the UK economy, the Bank of England are forecasting low inflation and low interest rates in 2010.
So, the interest rate will stay near zero until:
o Scale of Quantitative easing (increasing money supply) increases potential for future inflation. As inflation rises, interest rates could rise sharply. However, the impact of quantitative easing has not been fully understood. Broad money growth still shows slow growth.
o UK housing market could be bottoming out leading to slow recovery in house prices.
o As economy recovers at end of the year, the historic rates could rise to prevent inflation.
o Signs of rising oil prices
To sum up, now we can see that every time UK fells into recession the interest rate is reduced. It happened in every recession since 1980s, and it is happening now. It does not matters how big is the recession, what lead us to it, there always followed reduction in interest rate and there will always follow it.
All the numbers mentioned before you will find in graph in appendix 1.
Bibliography
Lewis M & Mizen P "Monetary Economics"
John Cole and Sunil Bhaduri "Introduction to Microeconomics"
First Edition
David Begg, Stanley Fisher and Rudiger Dornbusch "Economics"
8th Edition
www.economist.com
http://en.wikipedia.org
http://www.houseweb.co.uk/house/market/irfig.html
http://www.economicshelp.org/blog/interest-rates/interest-rate-cycle/
Appendix 1
http://www.houseweb.co.uk/house/market/graph.html
