Monetary Policies in the UK to Manage the Economy

1856 words (7 pages) Essay in Economics

08/02/20 Economics Reference this

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Describe how monetary policy is currently formulated in the United Kingdom and assess how effectively it can be used to manage the economy.

Monetary policy relates to the control and adjustment of money supply through monetary policymakers (Casu, Girardone & Molyneux, 2006). The aim is to secure price stability. Monetary Policy often involves inflation targeting as part of the framework and functions through reorientation of the demand-side, via adjustment of the interest rate set to banks and quantitative easing, which is the purchasing of a predetermined quantity of bonds to stimulate the economy and increase liquidity (Bullard, 2010). This essay will examine monetary policy in the United Kingdom, while also weighing the efficaciousness in controlling economic variables, which is contested between the seven main schools of economic thought. The debate involves the preferential use of the three main macroeconomic policies in managing an economy: monetary, fiscal and supply-side policy. empirical evidence will be evaluated.

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Monetary policy is a flexible policy which be used to achieve different goals. Monetary policy in the UK has operated under flexible inflation targeting since 1992. There has been alteration in the setting of monetary policy, such as the framework adapted in 1997 to allow central bank independence in decision making (McCafferty, 2017). This has allowed less manipulation in policy setting which aligns with political agenda, thus negating social and economic consequences in the longer term. In addition, there has been an aim to greater increase transparency via publication of inflation and monetary-policy reports (Haldane, 1997). The policy is carried out by the UK central bank, or more specifically the monetary policy committee (MPC). The policy is set and announced eight times a year. The MPC utilizes full dependence and is run by nine members, the estimated time lag for monetary policy by the Bank of England is two years. Thus, forecasting predictions of inflation and economic growth in the foreseeable future is critical. The procedure of setting new policy involves a summation of MPC meetings. It starts with a pre-MPC meeting, where members view the latest data and analysis on the economy. Then, there are two meetings regarding a discussion on the contemporaneous data and the future direction of monetary policy. Finally, there is a meeting where the Governor – currently Mark Carney recommends their favoured policy. Ultimately, the prevailing policy is chosen by a majority of votes. If the inflation target is missed, the Bank of England Act 1998 commands the Governor to write a letter to the Chancellor of the Exchequer explaining the solutions to rectify the problem, and the expected time period for inflation to remain outside the given target (Parkin, Powell & Matthews, 2007).

The effectiveness of monetary policy is contentious within Economics. There are seven main schools of economic thought, where each one has a differing view on the efficacy of monetary policy.  Classical economists such as Adam Smith, David Ricardo and Irving Fisher view monetary policy in the long run having no effects on real variables of the economy, and only leading to a higher price level (Chan-Lee & Kato, 1984). Analogously, fiscal policy under some assumptions has no use in affecting employment and output. If government spending were to increase, interest rates would rise and a complete crowding out of private investment would occur, however price level would remain unchanged. Thus, under this view demand-side policies such as monetary and fiscal policies merely affect the interest rate and or price level (Heijdra, 2009) while in dichotomy supply-side policies affect real wage, employment and output. There has been an evolution to the theory and became another school called new classical, with a heavier emphasis on mathematical techniques and the role of rational expectations (Greenwald & Stiglitz, 1987).

Keynesians use the phenomenon of the liquidity trap to argue the ineffectiveness of monetary policy. Suppose the rate of interest is sufficiently low analogous to the pervasive sub-zero rates observed currently. Also, that the level of spending at this interest rate is insufficient to support full employment of the factors of production, plus prices and wages are fully flexible. Under these conditions, Keynes argued that price and wage reductions will not restore equilibrium (Mankiw, 2015). Hence, market forces would not correct disequilibrium in the market. Monetary policy becomes ineffective, since the additional money supply will be absorbed by investors, and there would be no difference on the interest rate. However, fiscal policy would be proficient. Additional government spending would stimulate aggregate demand leading to an increase in employment and output. New Keynesians have reformed insights on Keynesianism. This view incorporates more microeconomics in analysis.  

The Neo-Keynesian synthesis view was developed by neoclassical economists; applying Keynesian properties in the short run and classical properties in the long run. In this view, expansionary monetary policies (expanding the money supply) would reduce the interest rate and increase aggregate demand. Thus, the price level increases, exacerbating the increase in national income. In the short run, the policy induces an increase in employment and output, and a fall in the interest rate. However, in the long run there are no changes to employment and output since the expected price level increases hence the aggregate supply also will increase to reach the original equilibrium of employment and output. Therefore, money is unneutral in the short run but neutral in the long run. Hence, monetary policy becomes ineffective in regard to affecting employment and output in the long run.

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Monetarists assume that the interest sensitivity of investment is highly elastic. Therefore, only a small change in interest rates have a significant role on investment decisions. Consequently, fiscal policy leads to significant crowding out of private investment (Heijdra, 2009). Under the assumptions, monetary policy affects real economic variables and is a far more effective way of managing the economy than fiscal policy. As there may be temporary effects on real output, leading to potential expansionary monetary policies used to overcome unemployment. Critically, adaptive expectations of economic agents must be assumed. Meaning that expectations in the future are based on past events. Although Freidman (1968) questions the effectiveness of monetary policy in dealing with aggregate demand and employment. This stems from the policy makers not utilizing adept timing, as well as significant time lags before the policy has the desired effect. The policy can have a counterproductive effect by accentuating business cycle fluctuations rather than smoothing the cyclical fluctuations if policy timing is unsatisfactory.

There has been a more neoteric school of thought that sides heavily with policy involving the supply side. Economists such as Arthur Laffer and Robert Mundell oppose government intervention in markets. They argue real output and unemployment are determined by supply factors such as technology, population growth or axioms of preference from economic agents (Casu, Girardone & Molyneux, 2006). Krugman argues that monetary policy becomes impotent during a liquidity trap. Since, nominal interests are near zero, money supply expansion will have no effect because money and bonds are perfect substitutes in the view of private investors. Monetary policy is deemed ineffective during a liquidity trap, since markets expect the policymaker to target price stability, hence view current policy as transitory. However, if the policymaker can credibly propose to negate its goal of price stability for seeking a higher future price level, then monetary policy theoretically can be effective during a liquidity trap (Krugman, 1998). Empirical evidence shows that Japan, once the second-largest economy in the world, has had a stagnant economy since 1991. Its money market rates have been close to zero percent since the mid-1990s, and the Bank of Japan plausibly claiming a lack of ability to recover. This is becoming a ubiquitous observation, the solution according to Krugman is for central banks to commit to higher inflation for a substantial period. Considering that an economy requires rising prices to ensure full employment. However, under the dubious assumption that prices are perfectly flexible, there is no need to generate inflation to avoid recession. (Wilson, 1999)

Empirically, monetary policy has been an effective influence on the UK economy. Inflation has become considerately more stable, after interpolating annual CPI data from ONS one can see the standard deviation of the inflation proxy was 0.85 during 1997 to 2018. The previous 22 years of data had a standard deviation of 6.05. The extent of which this reduction in variability is found in monetary policy changes is contested. Economic history has provided events which distort direct comparison, for example the 2007-09 recession or the recession of 1980/81 leading to the worst inflation level recorded at over 20% in 1980 which had prevailing effects until the late 1980s. However, the role of monetary policy has certainly contributed to the smoothing of inflation.

In conclusion, the theories agree that the effectiveness of monetary policy is contingent on the aim of the policy and the view behind it. As seen by most schools of economic thought, monetary policy is inadequate for targeting economic growth or productivity increases. It was apparent through the theory of long run neutrality of money, that long run changes in money supply create no permanent impact on real variables such as output or unemployment. Overall, it is apparent that monetary policy can be used to raise the growth potential of an economy by stabilizing prices. However, it cannot affect real variables in the long run sustainably.

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