1. Monetary policy involves central banks using interest rates, money supply, and exchange rates to influence the economy and meet targets like inflation. 2. The Bank of England sets the official interest rate in the UK and uses other tools like quantitative easing to boost the money supply when rates are low. 3. Changes in interest rates impact borrowing costs, spending, investment, and economic growth, but there are limits to how much lower rates can go and their effectiveness in boosting demand.

1. Monetary Policy
EdExcel AS Economics 2.6.2

2. What is Monetary Policy?
Monetary policy involves changes in interest rates, the supply of
money & credit and exchange rates to influence the economy
Market interest rates Bank Lending Currency markets
Inflation targets Bank of England European Central Bank

3. UK Monetary Policy – A Brief History
1980s
• Belief in the theory of monetarism, money supply targets
• Late 1980s – shadowing the German Mark to control inflation
1990-1992
• UK entered the EU exchange rate mechanism in October 1990
• A system of semi-fixed exchange rates – pegged to the Mark
1992-1997
• Sept 1992 – Sterling devalued / UK leaves ERM on Black Wednesday
• Move back to floating exchange rates – government still sets rates
1997 to 2015
• May 1997 - Bank of England made independent of government
• Monetary Policy Committee set up to set official interest rates

4. Interest Rates
An interest rate is the reward for saving and the cost of borrowing
expressed as a percentage of the money saved or borrowed
• There are many different interest rates in an economy
• 1/ Interest rates on savings in bank and other accounts
• 2/ Borrowing interest rates
• Mortgage interest rates (housing loans)
• Credit card interest rates and pay-day loans
• Interest rates on government and corporate bonds
• The Bank of England uses policy interest rates to help
regulate the economy and meet macro objectives

5. Policy Interest Rates in the UK Economy
When the Bank’s
policy interest rate
changes, most of
the other loan and
savings interest
rates in the
financial markets
will also change too
. The Bank of
England has left the
Base Rate in the UK
unchanged at 0.5%
since March 2009 –
the lowest since the
Bank was founded
in 1694
The policy interest rate is set each month by the Monetary Policy
Committee. The 2% inflation target is set by the government.
Euro Zone interest rates are set by the European Central Bank
Interest rates in the USA are set by the US Federal Reserve
UK interest rates are set by the Bank of England

6. Examples of Interest Rates on Loans in the UK
There are many different interest rates in a modern economy
• Bank loans
• Mortgages
• Credit card rates
• Payday loans
• Corporate bonds
• Government bonds
Latest interest rates
• Base interest rate 0.5%
• Two year fixed rate
mortgage 2%
• £10k unsecured loan 5%

7. Average Interest Rates for Types of Mortgage (2014)
The chart shows the average interest rate on mortgage (home)
loans in the UK in 2014. SVR = standard variable rate mortgage
2.37%
2.97%
3.47%
2.83%
4.43%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
2 year fixed rate
mortgages
3 year fixed
mortgage
5 year fixed
mortgage
Tracker
mortgages
SVR mortgages**
Averageinterestrate
Source: Bank of England

8. Monetary Policy Interest Rates for Selected Nations
2007 2008 2010 2012 2013 2015
Brazil 12.1 12.4 9.9 8.6 8.3 13.5
United States 5.1 2.1 0.1 0.1 0.1 0.3
Australia 6.4 6.7 4.4 3.7 2.7 2.1
China 2.3 2.8 1.8 2.3 2.3 1.6
Hong Kong,
China
6.6 3.4 0.5 0.5 0.5 0.5
India 7.7 8.0 5.5 8.1 7.5 7.3
Japan 0.5 0.5 0.1 0.1 0.1 0.1
New Zealand 8.3 5.0 3.0 2.5 2.5 3.5
Singapore 2.8 1.3 0.4 0.3 0.3 0.5
South Korea 4.7 4.8 2.2 3.1 2.6 1.7
Eurozone 3.9 3.7 1.0 0.9 0.6 0.1
United
Kingdom
5.5 4.7 0.5 0.5 0.5 0.5
Source: IMF

9. Expansionary and Deflationary Monetary Policy
Expansionary
Monetary Policy
Fall in nominal and real
interest rates
Measures to expand
supply of credit
Depreciation of the
exchange rate
Deflationary
Monetary Policy
Higher interest rates on
loans and savings
Tightening of credit supply
(loans harder to get)
Appreciation of the
exchange rate

10. Negative and Real Interest Rates
• The real rate of interest is important to businesses and
consumers when making spending and saving decisions
• The real rate of return on savings is the money rate of
interest minus the rate of inflation.
• So if a saver is receiving a money rate of interest of 6% but
price inflation is running at 3% per year, the real rate of
return on these savings is only + 3%.
• Real interest rates become negative when the nominal rate
of interest is less than inflation
• For example if inflation is 5% and nominal interest rates are
4%, the real cost of borrowing money is negative at -1%.
• Price deflation can lead to an increase in real interest rates

11. Factors Considered When Setting Policy Interest Rates
The BoE sets policy interest rates consistent with the need to meet
an inflation target of consumer price inflation of 2%
1. GDP growth and spare capacity / estimates of output gap
2. Bank lending, consumer credit figures, retail sales
3. Equity markets (share prices) and house prices
4. Consumer confidence and business confidence
5. Growth of wages, average earnings, labour productivity and
unit labour costs, surveys on labour shortages
6. Unemployment and employment data, unfilled vacancies
7. Trends in global foreign exchange markets (i.e. is sterling
appreciating or depreciation against other currencies)
8. International data – e.g. Growth rates in economies of
major trading partners such as USA and Euro Area

12. Transmission Mechanism of Monetary Policy
1 / Change in market
interest rates
2/ Impact on demand
3/ Effect on output,
jobs & investment
4/ Real GDP and Price
Inflation
Normally a change in policy interest rates
feeds through to borrowing/saving rates
Effect on spending, saving,
investment and exports
Is there an expansion of
production and employment?
Rate changes then affect two
of the key macro objectives
It can take between 12-24 months for the full effects on real GDP
and the inflation rate after a change in policy interest rates

13. When Interest Rates Fall
Cost of servicing loans / debt is reduced – boosting spending power
Consumer confidence should increase leading to more spending
Effective disposable income rises – lower mortgage costs
Business investment should be boosted e.g. Prospect of rising demand
Housing market effects – more demand and higher property prices
Exchange rate and exports – cheaper currency will increase exports
A reduction in interest rates or an increase in the supply of money
and credit is an expansionary or reflationary monetary policy
An expansionary monetary policy is designed to boost consumer
confidence and demand during a downturn / recession

14. Limits to the Effects of A Cut in Nominal Interest Rates
Commercial banks have been
reluctant / unable to lend
Low Business & Consumer
Confidence after the
recession
Falling real incomes
for millions of
savers
High stock of
personal debt holds
back demand
Some interest rates e.g.
credit card rates have
actually risen

15. What might happen if interest rates rise again?
MPC raises interest
rates
Signals tighter
monetary policy
Market interest
rates increase
Cost of borrowing
rises
Main effect will be
through via
mortgages
Possible slowdown
in housing market
And contraction in
retail credit
Higher rates might
also cause currency
appreciation
Makes UK exports
more expensive in
overseas markets

16. The Keynesian Liquidity Trap
A liquidity trap occurs when low interest rates and a high amount of
cash balances in the economy fail to stimulate aggregate demand
• In normal circumstances it is possible to boost demand by cutting interest
rates. But for most countries there is a zero floor for nominal interest rates
• Even if interest rates can be lowered this may have little effect if people
cannot or will not borrow. This is known as the liquidity trap.
• At this point, AD can only be boosted by the Government borrowing more,
either to spend directly or to give to others via tax cuts
• Keynesians believe that size of the fiscal multiplier effect is higher for
government spending than it is for tax cuts
• When private sector demand for goods and services is persistently low, the
government needs to find a compensating source of demand to rebalance
the economy – and the solution comes from the government in the form of
higher borrowing or less saving.

17. Interest Rates and the Distribution of Income
Incomes of savers
• If the interest on savings is less than inflation,
savers will see a reduction in their real incomes
Incomes of home-owners with mortgages
• If interest rates fall, the income of home-owners
who have variable-rate mortgages will increase
Interest rates on unsecured debt
• Lower interest rates on loans such as credit cards
and bank loans will fall
When interest rates fall, there is a re-distribution of income away
from lenders and savers towards borrowers with loans / debt

18. Quantitative Easing (QE)
• When policy interest rates are at zero or close to zero, there is a
limit to what conventional use of monetary policy can do
• In March 2009 the BoE started quantitative easing for first time.
• The main aim of QE is to support aggregate demand and avoid the
risk of a recession becoming a deflationary depression
• The Bank of England uses QE to increase the supply of money in
the banking system and encourage banks to lend at cheaper
interest rates – especially to small & medium sized businesses
• The Bank does not print new £10, £20 and £50 notes, it uses
money created by the central bank to buy government bonds
• There are doubts about the effectiveness of quantitative easing –
bank lending has struggled to recover since the end of the
recession. In the summer of 2015, QE totalled £375bn

19. How Quantitative Easing (QE) is meant to work
Central bank creates money electronically -
Adds money to their balance sheet
This money is used to buy financial assets -
Mainly the purchase of government bonds
More demand leads to higher prices for assets
e.g. bond prices. Rise in price of bonds leads to
a lower yield (%) on government bonds
Can feed through to fall in long term interest
rates e.g. mortgages and corporate bonds
Lower interest rates and increased cash in the
banking system should stimulate the economy

20. Main Challenges Facing the Bank of England
Controlling
consumer
price inflation
and keeping
inflation
expectations
low
Supporting a
sustainable /
durable
economic
recovery – a
return to
“normal
conditions”
Re-balancing
the economy
towards
exports (X)
and capital
investment (I)
Financial
stability –
building a
more secure
banking /
credit system
for the future

21. Forward Guidance when setting interest rates
• Forward Guidance was introduced by
Mark Carney in August 2013
• It has been signalled that the Bank of
England will leave their policy interest
rates unchanged as long as the
unemployment rate is above 7.0% and
inflation is under control
• The main aim is to build confidence by
signalling that interest rates would stay at
low levels for some time
• In 2014, Mark Carney signalled that
forward guidance would evolve – LFS
unemployment is not the sole data
measure to be used – they will look at a
range of measures of spare capacity

22. Has the Bank of England’s Monetary Policy helped?
Case for the
Bank of England
Avoided a damaging depression
Avoided sustained deflation + faster
growth than many EU nations
More competitive currency has
helped export sector to recover
Haven’t raised interest rates too
early – responding to Euro Crisis
Criticisms of the
Bank’s policy
Inflation allowed to rise well above
target in 2008 and 2012
Signs of another unsustainable
housing boom
Low interest rates have become less
effective e.g. in stimulating
investment
Britain has record current account
deficit – symptom of wider
structural problems

23. Financial Policy Committee of the BoE
In addition to the Monetary Policy Committee, there is a new body
at the Bank of England – the Financial Policy Committee (FPC)
• The FPC is charged with safeguarding financial stability
• The Monetary Policy Committee works through setting policy
interest rates and the scale of quantitative easing (QE)
• The Financial Policy Committee can operate directly on the supply
and price of credit in the banking system
• The FPC has the power to alter loan-to-value ratios (e.g. Ratio of
a mortgage loan to house prices)
• It can also change the cash reserve requirements or capital
buffers for commercial lenders – e.g. They might insist that banks
keep a higher proportion of new deposits in cash rather than lend
them out to businesses and households

24. Are low interest rates helping the UK economy?
Arguments that low interest rates are helping UK
macro performance
Counter-arguments – the disadvantages of low
interest rates
1. Keeping interest rates at 0.5% helps maintain
consumer & business confidence leading to
higher C+I and thus  AD. This is important
given continued slow growth in our main
export markets in Europe
• Savers have been hit badly by negative real
interest rates + income from pensions has
fallen – both are bad for long term economic
health. Raising interest rates will increase the
disposable incomes of millions of savers
2. If interest rates started to rise now, the £
would appreciate as hot money flowed into
the UK. This could choke off demand for UK
exports  negative multiplier effect and
some lost jobs in manufacturing businesses
• Low interest rates are causing another
unsustainable housing boom which in the long
run is damaging for the economy. We need
higher interest rates now to control mortgage
debt and learn lessons from 2007
3. At a time when the government is pursuing
fiscal austerity, it makes sense for interest
rate to remain low to keep the economy
growing and prevent deflation
• Deflation is due to external pressures e.g. oil
prices. Unemployment is falling (5.5%) and
wages are starting to rise (2%) so this is right
moment to start raising interest rates because
they take time to have an effect

25. Evaluation Points on Interest Rates & Monetary Policy
• Time lags should be considered when
analyzing effects of interest rate changes
• Monetary policy not an exact science –
consumers and businesses don’t always
behave in a standard textbook way!
• Many factors affect costs and prices which
can change the inflation risks in a country
• Monetary policy does not work in isolation!
Consider how fiscal policy can also affect
aggregate demand, output, jobs & prices
• Objectives of monetary policy can change –
e.g. the USA Federal Reserve’s mandate is
“maximum employment, stable prices, and
moderate long-term interest rates”

26. Monetary Policy
EdExcel AS Economics 2.6.2