History of the Monetary Policy in the UK - Essay Example

MONETARY POLICY FRAMEWORK IN THE UK Introduction Monetary policies are the central drivers of the economy of any country and affect the economic system of the world. Monetary polices are policies that are undertaken by the government through the central bank which controls the economy of a country. Monetary policies are important economic tools which affect the performance of the economy. For economic growth, there is need to have effective monetary policies. In this regard, the bank plays crucial role in ensuring that there are monetary polices that are aimed at monetary stability. This includes the stability in price and confidence of the economic. Stable price of products and confidence are important in controlling the inflation rate of the economy. The interest rates are controlled by the obligation of the government to control the inflation target in the economy. Hence the bank controlled the inflation rate through controlling the interest rates that are charged on the commercial banks. On the other hand financial stability includes protecting against threats to the whole financial system of a country. There are threat to the economic which are detected by the bank's surveillance and market intelligence functions which are dealt with through financial and other operations in the economy. These operations can be based at home or abroad. (Millard, 2006) All the above are important factors that are regulated through the monetary policies. In the UK, the Bank of England is bestowed with the role of a central bank. There is a monetary policy committee that deals with issues concerning the regulation of monetary policy in the economy. Throughout the history of the UK, there have been changes in the monetary policies that have helped to shape the economy of the UK. This paper will look closely at the way the monetary policies have been changing in the UK and look at the interaction that has been there between monetary polices and the inflation rate. At the end it will look at the recent monetary polices that have been implemented by the Bank of England and evaluate whether they were helpful or not. Let us first look at the history of monetary policies in the UK. (Hamilton, 2003) History of the monetary policy in the UK The UK monetary policy system has change over time to suit the changing environment. This has corresponded with the changing rate of inflation in the country which has been caused by many factors. In order to streamline the performance of the economy, the monetary policies have been likewise changing with time to suit the environment. The bank of England in conjunction with the parliamentary committee have been playing crucial role in the changing of monetary policies in the country. There change in monetary policies has been corresponding with the changes in the rate of inflations. The bases of inflation control have been the use of integrated strategies to control the great demand. This has been implemented in conjunction with the banking sector which has played a crucial role in offsetting the rate of inflation in the country and likewise through the monetary policies. (Benito and Wood, 2006) The most notable change in the monetary policies in the UK has been the change that took place in the 1990 due to the changing landscape of inflation. By the standards of history, the performance of the economy under the inflation rate of this time had been unique. Between the periods of 1972 to 1992, there was recorded the lowest size of business-cycle frequency fluctuation. The unemployment-inflation trade-off displayed the greater stability was the greatest ever and the rate of inflation was the highest ever. But since then there has been historically unprecedented stability in the economy. Many economists have argued that this cannot be attributed only to the monetary framework but it can also be attributed to good luck in the performance of the macro economic policies. This has also been attributed to substantial consolidation of the fiscal policy which turned a deficit of 8% in 1993 to a sustainable way for the public finances. This marked a continuing program of supply-side reforms over period of more that 25 years which saw reduction in unemployment while it generated low inflations rates. The most radical reforms in the fiscal policies starting in 1997 when the government decided to come up with strict measure as regards the functioning of the economy. For the fist time since the breaking of the Breton Woods system in 1970, the UK had at last discovered monitory policy that was able to control the inflation under an exchange rate that was floating. But although the success seems to have puzzled many people, the inflation control did not work as has been predicted by many economist theorists. (Cogley, 2005) In 1997, the Bank of England, a monetary system was introduced which gave the Bank of England operational independence and a target of 2.5% annual inflation. It was later changed to 2%. This was seen as a move that was supposed to change the economic landscape and make it more stable. It is evident the economic policies that have been implemented have helped to change the economic performance through the inflation rate. The inflation targeting regime has been more stable than the previous regimes of post world war II. The history of the UK monetary policy can be summaries by the different monetary regimes and economic performance that have been implemented throughout the history of the UK. De facto silver standard was a monetary regime implemented between 1661 and 1717. This was followed by the De facto gold standard implemented between 1718 till the 1797 at the time of wars with France. The De jure gold standard was applied from 1821 to the begging of the world wars in 1914. This was followed by the constitution period which was marked from the period of 1921 to 1939 when UK declared war with Germany. This was followed by Breton woods regime of 1946 to the floating of the pound against US dollar in 1972. This was followed by the introduction of inflation targeting which lasted till 1992. From 1992 up to 1997, there was a more radical inflation targeting regime. From, 1997, there was the introduction of the current monetary policies. Performance of inflation since 1990s The first inflation target was firm adopted in 1992. It was considered a new framework for monetary policy which worked to replace the hitherto provided the ERM. It was aimed at bring underlying inflation in the UK which was being measured by change in the retail prices excluding mortgage interest and other interest to be at par with the best monetary policies in the UK. This policy set the rat of inflation in the long run at 2% or less. Under the new regime there were no target rates for the exchange rate. (Borio and Lowe, 2002) Prior to the enactment of this policy the integrate rates had been rising since 1970s and the result seemed to continue for the rest of 1990s, however the introduction of this inflation targeted regime helped to check the rate of inflation in the economy. There was a dramatic change in the rate of inflation after this policy was adopted in the 1992. There was hope in the financial sector as the inflation was kept low. Having achieved this control of the regime, there was need to keep the rates of inflation further low and it was predicted that despite the conditions that the economy may finally face, there was need to keep it at a low of 2.5 % beyond 1997. Generally there was good performance of the inflation rate in the 1990s. The rate of inflation was arrested despite having soared in the previous regimes. The inflation targeting regime was specifically put in place with the aim of addressing interest rates which had kept soaring to higher points since then. The efforts that were made by the parliamentary committee and the Bank of England were at last giving light on the monetary policies. There was a great control of the inflation rate. (Bernaknke, 2003) Factors and mechanisms of inflation There are various factors that affect the interest rate of a country. The central bank uses various measures to offset the inflation but one of the most important determinants of the rate of inflation is the interest rates. The bank regulates the rate of inflation through a variety of monetary policies which are aimed at regulating the rate of inflation. The rate of inflation is a factor of interest rates that are charged by the bank mainly affected by the way the government borrows from the private players in the industry. This becomes a cycle where the bank may borrow from the central bank and later dispose off what it has borrowed. This is the way the bank regulate the amount of money that is being used in the economy. If the bank realizes that there is a lot of money that is flowing in the public domain, it will work to regulate this through domestic borrowing. Likewise when there is scarcity in the financial system, the bank will work to release what is has reserve bank to the public consumption. The treasury bills are an important tool that is used by banks to regulate this amount of money in the private and public hands. The Bank of England implements monetary policy by lending to the player in the money market. This is implemented at an official report rate which is chose by the monetary policy committee (MPC). The rate of the bank only changes when the MPC decides that it should. There is an arbitrage mechanism that ensures that the wish of the bank is reflected across the banking sector. The Bank in most case consults with the private players in the money market. It should introduce balance sheet asset which have been acquired from the counterparts which are the private operators in the market. They are mostly private sector obligations which are short term and a good number of them matures ever day. This translates to the fact that at each and every day, the private sector is likely to pay money to the central bank in order to redeem these obligations. The private sector players in most cases have to borrow additional funds from the bank which gives the central bank a chance to provide the funds once more at the official report rate. (Bean, 2002) Therefore the more the central bank borrows from the private player in the sector, the higher the rate of inflation is gonging to be. This is because the private sector will be facing a cash shortage and hence will be likely to charge more interest on the loans that customer borrowing from the banks. This brings the rate of inflation up. The central bank is given the role of regulating the amount of currency that is flowing in the market. Although this is determined by the forces of demand and supply there are instances where the bank can use various measures to regulate the amount of money in the public domain. (Banti, 2006) When there is a lot of money circulating in the public domain, the bank will borrow from the private sector in order to reduce the amount of money in circulation this offsets the interest rates and increased the rate of inflation. Therefore we can say that according to Keynesian view, contradiction monetary policies are likely to raise the rates of interest which in turn translate to increased cost of capital couple with a decline in investment and fall in outputs. The change in GDP affects the rate of inflation. In the long run, GDP is determined the supply side factors including technical progress, capital accumulation, size of the labour market, and other factors. However it has been shown that monetary policies have little effect on the Long run growth rate of a nation. On the same not the financial banks plays an important role in the financial change. The public borrow and makes deposit from the bank. As a result, the public has become dependant on the financial system of the player in the monetary institution. This cycle of dependency means that the customer will be gong to the bank to get money for spending. This affects the rate of spending of customers. Therefore, the rates of interest that a bank charges on any money that is borrowed from the institution have a lot of influence on spending power of the customers. Therefore the way the central bank regulations the flow of money in the public domain has a lot of influence in the spending power of the public. (Bean, 1998) Recent decision by the Bank of England The coming of labour government in 1997 marked a starting of new fiscal polices that were more inflation targeted than the ones that had been implemented in 1992. There was a crucial change in regime in 1997 the came with the new Exchequer Gordon Brown. This came with the announcement that the government was giving Bank operation responsibility for setting interest rates. This was considered as an instrumental independence which should come with introduction of new regimes later. The Exchequer therefore reduced its influence on the making of monetary policies but could interview only when it was needed. (King, 2005) In 1998 the Bank of England Act was introduced which was an amendment of the 1946 act. The act was in line with giving the Bank the role to develop monetary police objective that that were targeted to deliver price stability. This was to work as per the government inflation target and would also work to support government economic policies. This was largely aimed at addressing the rate of economic growth and employment. There economic police at that time were addressed to economic growth and employment which were tow subject that had led to high inflation rates prior to the 1992 introduction of monetary policies. The objective of 1992 policy was to achieve underlying inflation as measure by the RPI excluding mortgage interest rates of 2.5%. (Proudman and Vlieghe, 2002) There was the introduction of the point target which actually involved no band or gauge. The specification of the target was also described as symmetric which means it could be the original 2.5% or less than that. Since then to 2003, the exchequer always announced the inflation target in the budget statement. But in 2003, the exchequer changed the inflation target to one that was expressed in terms of growth in annually which was to be measure the consumer prices index (CPI) instead of RPIX. At this time, the target was set at 2% CPI inflation. It was also made clear that the economy should also target and achieve this all times. RPIX is different from CPI in just a mater of composition. RPIX includes measure of owner occupied housing costs, insurance for building and taxes levied by the councils which are not included in the CPI. But together the cost of all the above can account to 9% of the RPIX in goods and services. There are some goods and services which appear in both of the above but which are measured using different indices. For example, cars in which RPIX uses only prices of second hand cars while the CPI uses the price of new and used cars. In terms of coverage they differ in the sense that RPIX excludes expenditures by the higher 4% earners to average any goods to the UK average household. The CPI includes all expenditures of private households and residents and from all visitors to the country. This means it looks at spending by all consumers. (Barwell, 2000) However under the new reforms the government still holds the right to control the exchange rate polices of the country. The bank has a different separate pool of foreign exchange reserve that is used on own discretion in support to monetary policy objective. The bank has the role of acting as the government debt management and ensures that all sales on behalf of the government are made and transferred to the treasury. The monetary policy that was set up in 1997 still meets on monthly bases. It is comprise of 9 members who are supposed to enhance accountability in the function of monetary policies in the country. However since the implement to the policies, the rate of interact in the economic has been resign since 2002. Almost six years from then, the bank has not been able to maintain the rates of inflation that had prevailed in the 1990s. It appears like the country is back to the crisis of the period between 1970s and 1992. The CPI shows that there has been increasing rate of inflation and it has raise from 0.75 in 2000 to almost 2.5 in 2008. Therefore ewe can say that through the policies implemented were supposed to raise the growth but they have not been able to chive this instead the interest rate has continued to skyrocket. It could have been more appropriate if the ban continued with the monetary policies that were implemented in the early 1990s. The recent monetary policies have been of help to the government but they have not helped to lower ht rate of inflation. This reflect the comment that were made by economist in the 1990s who argued that the rest in inflation that was being experienced in the 1990s could have been due to a mater of luck rather that the effectiveness of the monetary police that had been put in place. Conclusion Compared to the past performance of the economy we can say the rate of inflation in the UK had been controlled since the inception of the inflation targeting regimes. At the same time the rate of growth of GDP can be considered to have been stable over that period of time. This is a clear reflection of the effectiveness of the inflation targeting regime that took place since 1992. In deed we can say that this framework ahs been able to reduce the sensitive of the inflation to demand and cost shocks. But there have been other factors that have also played a part in establishing the monetary regime. This has particularly been contributed by the rising trade between nations due to the coming of European Union and the increased trade with the outside world. Cheaper import and increased competitive pressures that are associated with globalization increase in labour supply which is associated with inward migration of people to the UK. These are two aspects that have reduced inflationary pressures on the economy. All this has been associated with changes that have been implemented in the monetary regimes. Therefore we can say that these monetary policies were supposed to be implemented since they have helped to cut the rate of inflation which has a big problem for a long time in the country. They have been beneficial to the economy and tot that people but there is need to put more measure to bring the rate of inflation low. Reference: Banti, L (2006). 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