Explain how monetary policy can be used to control the performance of the UK economy (10)
Explain how monetary policy can be used to control the performance of the UK economy (10)
Monetary policy involves changes in the base rate of interest and the money supply (effectively the amount of bank credit available for borrowing). The aim is to influence the rate of growth of aggregate demand and thus inflation. The government’s four main objectives are low and stable inflation, low unemployment, maintaining current account equilibrium and high but stable economic growth.
The main objective of monetary policy is to control inflation. Since 1997 the Bank of England has been given operational responsibility for monetary policy. The current target for inflation set by the government using the CPI measure is 2%, although it is allowed to deviate 1% either way of the central target. Higher interest rates will reduce inflation because they reduce consumption and investment. This is because the opportunity cost of saving has increased so consumers would be more inclined to save, and less inclined to borrow. Investment would decrease because it becomes more expensive for firms to borrow money for capital unless they reduce their profit margins, which is unlikely, so investment would decrease. Monthly repayments on existing variable rate debt (especially mortgages) increase, leaving less disposable income for spending on goods and services. Aggregate demand will fall (AD1 to AD2) as a consequence, as consumption and investment are two of its components. Consequently there will be a fall in the price level (P to P1) meaning a reduction in inflation.
