Monetary Policy and how it Functions

Economic stability and growth are important macroeconomic goals that are must be pursued by all countries. To realize a steady and stable economic growth and development, it is important for the government through its relevance agencies to establish sound and sustainable economic policies. This starts from the macro and the micro level of the economy. The economic stability of a country/state depends on the effectiveness of economic policies advanced in order to regulate the economic activities with the country both at the domestic and international levels. Therefore, to realize economic stability, it is paramount for the economic policies enacted are correspondent with the state of the country in terms of resources and economic endowments. Two approaches are used to realize the economic goals of price stability, economic growth and development, and stability in the exchange rates. These two ways include monetary policy and fiscal policy mechanisms. While fiscal policy frameworks focuses on fiscal components such government expenditure, taxation, and subsidies, the monetary policy on the other hand represents policies enacted to regulate the flow of money in the economy. Besides, monetary policy mechanisms are used by the financial institutions to regulate effective interest rate. The main objective of regulating the flow of money in the economy is to stabilize the currency and control inflation within a manageable or planned level. Monetary policy is an effective policy framework of the Central Bank of England that impacts on the effective cost of borrowing which has a direct effect on the amount of money in circulation and consumer expenditure. The stability of the monetary policy is measured by the stable prices, stable exchange rates (confidence in currency), and low inflation rate. All the key decisions regarding the monetary policy are made by Monetary Policy Committee.

MPC of the Bank of England

The Bank of England through its Monetary Policy Committee attempts to regulate and influence the general economic pattern and expenditure by changing its official interest rates. This is because it is important to maintain a steady growth rate between the level of output and money expenditure in the economy so as to eliminate inflation. Through this approach, the MPC therefore desire to control inflation by adjusting interest rates either upward or downward. After setting the national renting rate to major financial institutions, these rates affects the entire economy from building societies, trading institutions, to consumers. Besides, the interest rates set by the MPC of the Bank of England is reflected in the exchange rates markets and equity stock markets. The Bank of England’s Monetary Policy Committee (MPC) charged with the responsibility of determining the interest rates was accorded the power by the Labour Government 1997 following periods of high inflation rates and soaring bench mark of 15% after it was realized that Ministerial interest rate control was ineffective in maintaining long-term sustainable economic stability since the economic decision were clouded by political factors. The MPC of the Bank of England is a nine member committee chaired by the Governor of the Bank of England, the Deputy Governors, four appointees by the Chancellor, Chief Economist, and Executive Directors of the Market Operation.





Monetary Policy Statistics (2002-2012)

Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
CPI 1.3 1.4 1.4 2.0 2.3 2.3 3.6 2.2 3.3 4.5 2.7
Interests Rates 4.0 3.75 4.75 4.5 5.0 5.5 4.6 0.6 0.5 0.5 0.5

From these statics, it is observed that the MPC of the Bank of England has been very consistent in its policies and interest rates. From 2002 to 2012, the highest inflation rate ever reported in England is 4.5% in 2011 while the lowest inflation rate in the economy of England is 1.3% recorded in 2002.  However, over this eleven year period, the Monetary Policy Committee has been able to contain the inflation rate within the planned limits except in 2011 when the CPI surpassed the planned level. It is also observed that the CPI has not been very steady as it keeps on fluctuating.  Concerning the interest rates or the benchmark, the trend in the interest rates has been declining. In 2007 following the global financial crisis, the benchmark rates was very high at 5.5% making the cost of borrowing expensive and driving out investments. However, the MPC defended their decision of raising the interest rates citing the global financial contagion as being the reason. After the economic stability through financial bailouts to the financially crippled nations, the monetary policy committee reduced the cost of borrowing funds to 0.5% so as to stimulate economic growth and investments. The MPC has since then kept the bank interest rates constant at 0.5%.

Evaluation of Monetary Policy

Monetary policy is effective in regulating the economic activities of England since interest rates have powerful and direct influence on the consumer expenditures, and indication that the consumption of is interest elastic. The Bank of England’s Monetary Policy Committee operates as an independent unit free from any political influence or interference. The interest rates will be adjusted monthly unlike the discretionary fiscal policies which are very static and cannot be adjusted on regular intervals. The effects of changes in the interest rate are immediate as they may be experienced in the economy within a very short period of time unlike the fiscal mechanisms which are often experience after half a year.

Although monetary policy is effective in delivering the desired results of economic stability within a very short time, the use of interest rate as an economic stabilizer is limited to some extent. Some of the limitations of the monetary policy (interest rate mechanism) include the need for more time lags to observe the full impacts of this policy on the general economy, and the negative implication associated with the interest rate policy. The major weakness of the monetary policy mechanism (where interest rates are preferred as the economic stabilize) is the liquidity trap. At the liquidity trap level, the demand in the money economy is insensitive to any change in the interest rates. At this point, the interest rates are too low to instigate changes in the demand or supply of credits, hence inelastic. The dual-economy where booming sectors of the economy are subjected to higher interest rates while the depressed sectors are stimulated through reduced interest rates is another limitation of monetary policies in the case of England. In addition, change in the interest rates negatives affects the BOP (balance of payment) through reduced investment expenditure.

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