The Bank of England Challenges - Assignment Example

The Bank of England's two core purposes are monetary stability and financial stability. Monetary stability means stable prices - low inflation - and confidence in the currency and financial stability entails detecting and reducing threats to the financial system as a whole” (Source: Bank of England http://www.bankofengland.co.uk/monetarypolicy/index.htm) Prepare a report explaining in relation to the UK. 1) How the rate of inflation has affected the interest rates over the last five years? The Bank Of England was given the responsibility of managing interest rates, currency exchange rate levels, and also attempting to manage inflation rates during the early 1990s (Bannock, Baxter, & Davis, 2003 p.21). At that point, the Bank Of England was not fully independent of interference from the British government when it came to the setting of interest rates, lowering inflation levels, or indeed the management of currency exchange rate levels with other major currencies such as the Euro and the US$. Aside from the British government, membership of the European Union has played a role in the Bank Of England’s decision-making processes in relation to interest rates and currency exchange rate levels in the last five years (www.bankofengland.co.uk/monetarypolicy/index.htm). At the beginning of the five years period being studied here, it seemed that the Bank Of England had managed to use interest rate levels to maintain low inflation levels, strong economic growth as well as a stable level of currency exchange rate levels (Bannock, Baxter, & Davis, 2003 p. 21). British governments had previously found it very difficult to achieve such economic balances for more than limited short –term periods if at all. British governments had either achieved higher levels of economic growth with increasing levels of inflation, or had controlled the levels of inflation at the cost of lower rates of economic growth. British governments were frequently tempted to lower interest rates before calling general elections, actions which were taken in order to promote higher levels of unsustainable economic growth and a feeling of improved prosperity for the majority of the electorate to increase their chanced of being re-elected. Ending the politically inspired cycles of boom and bust was one of the principle reasons for the New Labour government giving the Bank of England full autonomy (www.bankofengland.co.uk/monetarypolicy/index.htm). The Bank of England is no fully independent when it comes to setting interest rates to contain inflationary pressures and maintain the exchange rate stability of sterling in relation to all the major currencies (Bannock, Baxter, & Davis, 2003 p. 21). At the start of the five year period in 2002, the Bank of England and the New Labour government had continued to benefit from the high economic growth levels, declining inflation levels and lower interest rates that had begun under the previous Conservative governments. That period of economic growth had commenced ironically, enough after the Major government had been forced to withdraw from the ERM when currency speculation forced a drastic devaluation of the GBP (Bannock, Baxter, & Davis, 2003 p.21). Leaving the ERM meant that both the British government and the Bank of England no longer have to worry about raising interest rates to keep sterling at fixed levels in relation to the Euro (Nicholson, 2002 p. 36). Interest rate levels were low and the Bank of England was able to avoid increasing those base rate levels until 2006 as inflation remained low and within the targets set by the Bank of England’s monetary committees, and the GBP was not at risk of being devalued (www.bankofengland.co.uk/monetarypolicy/index.htm). However, the Bank of England has had to raise interest rate levels for a variety of reasons, some domestic in origin, and other reasons international in their origin. The main reason for the Bank of England raising interest rate levels has been the higher levels of inflation caused by higher levels of consumer spending, higher house prices, and higher global prices for oil and natural gas. The former have strictly domestic causes, whilst the latter was caused, or at least intensified by international instability resulting from the war on terror. Increasing interest rate levels would certainly dampen the domestic causes of inflation, yet would be less likely to affect the international price rises that British companies are not to avoid, most obviously higher oil prices (www.bankofengland.co.uk/monetarypolicy/index.htm). 2) How the exchange rates of GBP has changed relative to the US$, and how this is related to changes in the interest rates over the last five years? The way in which the Bank Of England managed interest rates has had a strong influence upon the currency exchange rate levels between the GBP and the US$ in the last five years. The currency exchange rate levels have had important economic consequences during this period. Traditionally, British governments attached great symbolic if not always great economic significance to the currency exchange rate levels between the GBP and the US$ (Bannock, Baxter, & Davis, 2003 p.21). British governments were committed to maintaining the level of sterling at the levels agreed via the Bretton Woods arrangements. However, governments have not always been prepared to raise interest rate levels to maintain the GBP at agreed levels, as high interest rates were seen as detrimental to both economic growth and electoral success (www.bankofengland.co.uk/monetarypolicy/index.htm). Past devaluations of British sterling in relation to the US$ have not been witnessed in the last five year period, as the New Labour government was determined to avoid the humiliation such events bestowed on previous Labour administrations. To a very large extent the strength of the GBP in relation to the US$ is a significant consequence of the Bank of England being chiefly responsible for setting and moving interest rate levels up and down in Britain. That power and freedom of action allows the Bank of England to control domestic inflation levels as well as maintaining currency exchange rate levels at consistent financial values (www.bankofengland.co.uk/monetarypolicy/index.htm). The level of currency exchange rates between the GBP and the US$ is highly important due to the large volume of trade between Britain and the US. The fact that many of the world’s major commodities, most notably crude oil and natural gas are priced in US$ raises the important of the GBP exchange rate with the US$. The Bank of England is well of the importance of getting the currency exchange rate between the GBP and the US$ as well balanced as is possible (Nicholson, 2002 p36). If the value of the GBP is too high then British goods and services becomes too expensive leading to declining international exports and profits. On the other hand, if the value of the GBP drops too low in relation to the US$ then British exports are cheaper, but so are foreign imports. An undervalued or devalued currency exchange rate level can boost economic growth at the expense of higher levels of inflation. In the last five years the GBP has over all increased its value in relation to the US$, partly because of the interest rate level policy followed by the Bank of England. However, the high value of the GBP in relation to the US$ has not prevented the rate of inflation creeping upwards during the last five years. International instability especially in the Middle East has driven up the prices paid for crude oil and natural gas, thus increasing inflationary pressures in Britain since 2001. More expensive fuel and heating costs have been major contributory factors in the Bank of England moving to raise interest rates (www.bankofengland.co.uk/monetarypolicy/index.htm). The Bank of England might be able to set interest rate levels yet is incapable of influencing Britain’s foreign and defence policies, or those of its main ally, the US. The US$ has spent the majority of the last five years declining in value in relation to the GBP as well as most of the other leading international currencies such as the Euro and the Japanese Yen. The Bank of England has not had to pay as much attention to currency exchange rate levels in the last five years as it might have done if the British government had decided to join the Euro. As it is the Bank of England has had greater freedom of action during this period as the New Labour government had effectively ruled out Britain joining the Euro in the next few years (www.bankofengland.co.uk/monetarypolicy/index.htm). 3) Give a summary of the challenges you think the UK financial market will face over the next ten years? Justify your opinion There are several potential or actual challenges facing the British economy in the next ten years. The Bank Of England has concerns with regard to the viability of the financial markets within the UK during the next ten years, as does the British government and various financial institutions. These are concerns that seem to have a strong link with the challenges that face the British economy in the next decade or so. A major concern is that the Bank of England’s recent rises in interest rate levels will not quickly succeed in lower inflation rates which will in turn lead to further increases in interest rate levels. The higher interest rate levels become the more detrimental their affects will be on the performance of the British economy in the next ten years. Past experience has amply demonstrated that prolonged periods of high interest levels do indeed lower the rate of inflation. However, there have frequently been high social, economic, and political costs linked with such anti-inflationary policies. For instance, higher levels of unemployment, the further contraction of British industry, and increasing numbers of people having their homes reprocessed (Nicholson, 2002 p. 36). Another important, arguably vital challenge to the British economy within the next ten years relates to how Britain’s economic and political relationship with the European Union alters during this period, and that would be beneficial or detrimental (www.bankofengland.co.uk/monetarypolicy/index.htm). The European Union has an increasing influence over the British economy, and that influence would increase still further if the British government decided that Britain should join the Euro. Such a decision would drastically alter the amount of power and influence that both the British government and the Bank of England have over economic policies. The Bank of England would have to set interest rate and currency exchange rate levels in accordance with convergence criteria set by the European Union. Eventually, the Bank of England would cease to exist once Britain had fully adopted the Euro (Bannock, Baxter, & Davis, 2003 p. 21). Bibliography Bannock G, Baxter R E, & Davis E, (2003) Dictionary of Economics, 7th edition, Penguin, London Nicholson M (2002), International Relations – A concise introduction 2nd edition, Palgrave, Basingstoke www.bankofengland.co.uk/monetarypolicy/index.htm Read More