Explain why the control of inflation is an important objective of government economic policy.

Explain why the control of inflation is an important objective of government economic policy.

Although monetary policy can be used to affect many things, the main objective of monetary policy is the control of inflation. The target for inflation set by the government is 2.5%. Ever since the UK fell out of the Exchange Rate Mechanism (ERM) in September 1992, UK monetary policy has involved using interest rates to control the level of inflation.

There are very close links between the rate of interest, the money supply and the exchange rate. At times when the UK has been tied to a fixed exchange rate system (like the Bretton Woods system after the Second World War, and, more recently, the ERM), both the rate of interest and the supply of money have to be adjusted to maintain the goal of the fixed exchange rate. When the UK was part of the ERM from 1990 to 1992, the UK government effectively lost control of interest rates and, to a certain extent, the supply of money.

So, a government’s monetary policy consists of the control of interest rates, the money supply or the exchange rate. It is difficult to control two or more of these things at once.

UK monetary policy - from ‘Thatcher’s experiment’ to the ERM

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So, a government’s monetary policy consists of the control of interest rates, the money supply or the exchange rate. It is difficult to control two or more of these things at once.

UK monetary policy - from ‘Thatcher’s experiment’ to the ERM

The policy of controlling the money supply of the early 80s did not quite work as intended. Nigel Lawson, the Chancellor at the time, decided to ‘shadow’ the Deutschmark (DM). From 1987, he decided that the UK should ‘pretend’ to be in the ERM. The idea of fixing the £ to the DM was that inflationary devaluations would not be possible, so inflation should be kept under control. Also, as industry could not rely on a fall in the value of the £ to restore competitiveness, they would simple have to become more efficient. The higher value of the £ would impose discipline on UK industry, and hopefully UK inflation would be forced down to the level of Germany’s.

Of course, in the late 80s, the consumer boom out-weighed any deflationary effects of a stronger £. Inflation rose and interest rates rose to 15%

Did the UK have a monetary policy based on the exchange rate or interest rates? Thatcher wanted to use interest rates. Her belief in markets made it hard for her to accept controls on the value of the £ (exchange rates are determined in currency markets after all). For various political reasons, though, her hand was forced and the UK joined the ERM in October 1990.

The £ was now officially fixed against nearly all of Europe’s currencies (although its value was allowed to adjust by 6% - it was not a totally fixed exchange rate system). The UK government effectively had no control over their rate of interest. If Germany changed their interest rates, the UK soon followed, otherwise the value of the £ would change. Although nominal UK interest rates fell, real interest rates stayed very high, which was disastrous given that the economy was in a deep recession. The value of the £ was too high. The government knew it and the markets knew it. For most of 1992, the £ was at the bottom of the allowed band within the ERM. The markets were selling the £ and the only buyer was the UK government!

Eventually the pressure was too much. Having spent billions of pounds supporting the £, on the 16th September 1992 the Chancellor raised interest rates from 10% to 12% at lunchtime (a huge rise given today’s quarter point changes). The markets laughed, saw it as a sign of weakness and just kept selling. Rates were raised again on the same day to 15%, to take effect the following morning. The selling continued. The UK government threw in the towel and pulled out of the ERM. The £ instantly devalued by 15%. Interest rates went back down to 10% (the same rate as that morning!). The government had lost billions of pounds. This day was known as ‘Black Wednesday’ although many economists now refer to it as ‘White Wednesday’ because from that day onwards, interest rates were able to fall further, the value of the £ was much lower and the economy began to recover. For some, the 16th September 1992 was the last day of the 1990-2 recession.

Peer Reviews

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groat

3rd of Mar 2012

Quality of writing

This essay has a poor structure, not setting up a clear argument with the introduction but instead going completely off focus. I would've liked to see a structure which included the negative effects of inflation, the few positive effects, then an evaluative paragraph explaining why it is important to maintain the low inflation rate, drawing upon the negative effects explained. The essay is colloquial at times, using phrases such as "The UK government threw in the towel" which have no place in a formal essay. Being colloquial simply detracts from the analysis, and in some exams you will be penalised for quality of written communication! Spelling, punctuation and grammar are fine. I would note that it's not sophisticated to put Ã‚Â£ every time you mention the pound.

Level of analysis

The analysis in this essay is okay, given that it doesn't wholly contribute to answering the question. There is good awareness of why the inflation rate rose in Thatcher's period, which shows a good understanding of the importance of monetary policy. In the last paragraph there is some discussion of the effect of high inflation, albeit not technically put. "The markets laughed" could be better phrased as "International investors saw the UK economy as weak, and so would not invest into the UK" or saying "International buyers saw the UK products as over-priced for their quality due to their roaring inflation, choosing to go elsewhere". Consequences such as those should be considered, yet international effects aren't the only ones. When talking about inflation, I always talk about UK competitiveness, but then go onto discuss the problem of a wage-price spiral. Inflation causes prices to rise, which causes workers to demand a higher wage, which in turn forces firms to increase their prices. Such analysis would've been useful here and would gain credit.

Response to question

This essay doesn't engage with the question well, not discussing why controlling inflation is important. Instead of focusing on monetary policies to control inflation, I would be analysing the costs of high inflation. This would then lead to an evaluative judgement saying that these costs mean maintaining a low and stable rate of inflation is very important. Unfortunately, this essay decides to spend too much time looking at monetary policies.

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