UK Monetary Policy - Does it Work
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The main instrument of UK monetary policy is the use of interest rates, set
by the MPC. The theory is that interest rates are very effective in controlling
inflationary pressures. The relative success of meeting the government’s
inflation target in the past 7 years suggests that this proves the effectiveness
of monetary policy.
In brief raising interest rates helps to reduce Aggregate demand in the
economy. When interest rates are raised several things are affected. Firstly
those with mortgages have higher monthly payments, this reduces their disposable
income and reduces their spending. Secondly there is an increased incentive to
save money rather than spend. Thirdly those who have other forms of borrowing
will be hit with increased interest repayments, it will also discourage people
from buying on credit. Therefore in principal raising interest rates will reduce
demand and prevent the economy from overheating. This enables inflationary
pressures to be subdued.
However there are various factors which make interest rates less reliable as
a means of monetary policy.
1. Firstly there is a long time lag before interest rates have an effect.
People with loans will not stop their spending just because of interest rates
rise. However in the future it may discourage people from borrowing and
investing because of the higher interest rates. It is estimated interest rates
can take 18 months to have a full effect. This is why Monetary policy is
pre-emptive. The MPC try to predict inflation trends in the future and change
interest rates before inflation increases.
2. Related to the last point is the difficulty of predicting future inflation
trends. For example accurate information about the current state of the housing
market is often difficult to obtain. If statistics about the current state of
the housing market are difficult to obtain it shows how difficult it is to
predict future statistics like house prices ( a cursory glance at predictions
for house prices shows a wide range of forecasts)
3. Interest rates have different effects on different types of consumers.
When interest rates rise, those with new large mortgages definitely feel a very
painful financial squeezing. Even one quarter of a % can have a big impact on
their monthly payments. However it is worth remembering that a large % of the
population do not have very high mortgage payments. They have either paid off a
large proportion of their mortgage or they are renting. Thus higher interest
rates reduce the spending but only of a certain section of the population. Those
with large savings may feel better off because they are getting higher interest
payments each year.
4. It depends on consumer confidence. Higher interest rates may reduce
people’s disposable income however if they are very confident about future
income prospects they may not reduce there spending, confidence is a very
important factor effecting consumer spending, it can have an unknown effect on
UK monetary policy.
5. Higher interest rates have an effect on the £, increasing its value making
it more difficult for exporters. Again this is often an unwanted side effect of
monetary policy. Therefore monetary policy often has a more than proportionate
effect on the manufacturing / export sector.
About the Author
R.Pettinger is an Economics teacher at Oxford and writes frequently on the UK
economy and mortgages. He edits a site about Mortgages including a guide to
different types of mortgages.
http://www.mortgageguideuk.co.uk/
Follow us @Scopulus_News
Article Published/Sorted/Amended on Scopulus 2007-03-25 20:10:39 in Economic Articles
