Monday, March 5, 2007

What determines effectiveness of Monetary Policy in UK?

The aim of monetary policy is to achieve the governments inflation target of CPI= 2% +/-1. They will also consider impact on economic growth and unemployment. But control of inflation is their primary objective.

Factors which determine success of Monetary Policy

  1. Accuracy of inflation forecasts. Monetary policy is pre emptive which means they try to reduce inflationary pressures before they occur. If inflation is higher than predicted, then interest rates will be too low to control inflation. Inflation predictions could be wrong if there is an unexpected rise in cost push inflation, for example an increase in the price of oil. In the past 15 years the MPC have benefited from generally low global inflation, However some economists feel that this “golden era” of price stability may not continue indefinitely. E.g. economic shocks associated with rising commodity prices.
  1. Time lags. It is estimated interest rate changes can take upto 18 months to have their full effects. For example if interest rates rise then people who are currently spending on investment will not stop straight away. They will continue with their project. However higher interest rates may deter future projects from starting. By the time interest rates have had their desired effect it may be too late to reduce inflation. (This is why the MPC is always trying to predict future inflation trends)
  1. Interest Elasticity of Demand. This measures how responsive demand is to a change in interest rates. For example if consumer confidence is very high then higher interest rates may not deter consumer spending. This is because people expect to make more money in the future so are willing to borrow at higher levels of interest.
  1. Effects of interest rates not equally shared. The effect of rising interest rates effects some much more than others. For example in the UK many have high levels of debt through mortgages. Thus first time buyers with large mortgages will be effected by interest rate changes much more than older people who have paid off most of their mortgages. To reduce inflation may cause financial hardship for a small % of the population who have very high levels of mortgage debt.

  1. Other Variables. Interest rates effect other variables in the economy. Higher interest rates increase the value of the £ (through hot money flows). This causes problems for exporters and may worsen current account. Higher interest rates also have a disproportionate effect on the volatile UK housing market.

  1. Inflation expectations. The success of monetary policy depends upon credibility of the Monetary authorities. If people have low inflation expectations then it is much easier to keep inflation low. Since independence the MPC have benefited from a reduction in inflation expectations. This is partly due to the credence people give to an independent body rather than politicians with a poor track record of keeping inflation low.

  1. Levels of Government debt. High levels of government debt generally put upward pressure on interest rates. This is because to attract enough people to buy government bonds interest rates on these securities need to rise. This puts upward pressure on interest rates throughout the economy.

Note in Japan Monetary policy became ineffective because they experience deflation. Because interest rates cannot fall below 0% this meant the Japanese real interest rates were too high for the state of the economy. Monetary policy could not be used to reflate the economy. However deflation is unlikely to be a real problem in UK for the foreseeable future.

See also: Should primary objective of the UK be low inflation of 2%?

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