Monday, September 24, 2007

How the MPC Set Interest Rates

  • The MPC's primary objective is to keep CPI inflation close to the government's target of 2% +/- 1

1. The MPC try to predict future inflation trends. They look at various economic indicators to see whether the economy is growing too fast. For example if the economy is approaching full capacity then inflation is likely to increase. Therefore they look at statistics such as:

  • GDP growth (If GDP growth is above LRTR inflation is likely to occur.
  • Inflation
  • Unemployment, (low unemployment indicates potential for wage push inflation)
  • Exchange Rate (devaluation increases inflationary pressure)
  • Cost of Raw Materials
  • Consumer Confidence
  • House Prices
  • Stock Market Levels

2. Set Interest Rates.
If inflation is likely to go above the inflation target. The MPC will increase interest rates.

3. How Interest Rates Affect Inflation.
Higher interest rates help reduce the rate of economic growth and therefore reduce inflation because:

  1. Higher interest rates increase the cost of borrowing. Therefore consumers are less willing to buy on credit. Firms are less willing to borrow to invest.
  2. Higher interest rates increase the return from saving. Therefore consumers may spend less and save more.
  3. Higher interest rates increase monthly mortgage repayments. Therefore, homeowners have less disposable income after paying their mortgage. This point is increasingly significant given the levels of debt in the UK.
  4. Higher interest rates increase the value of the Pound. (more attractive to make deposits in the UK, causing hot money flows). The stronger pound reduces exports and increases quantity of imports. Therefore, AD falls.
Higher interest rates may also reduce demand for houses and if house prices fall it will cause a negative wealth effect which will reduce consumer spending.

4. If inflation is forecast to fall below target, or if the MPC is concerned about a slowdown in the economy then the MPC will cut interest rates.

5. The MPC meet once a month to set rates.

6. If inflation goes above or below target the MPC have to write a letter of explanation to the Chancellor of the Exchequer

See also:

No comments: