Monetary Policy of the Bank of England - Essay Example

?Introduction Inflation can pose serious threats to an economy because of its power to erode the economic growth and the purchasing power of money. Consistently high level of inflation therefore is considered as detrimental for the growth in the economy and can seriously undermine the growth prospects both in the short as well as in the long run. UK’s inflation rate has been soaring at the rate of 4% 1and there is a strong probability that the same can further increase in the future. At this time when economy is at a very fragile point, such higher level of inflation can actually discourage the consumers from spending and thus further putting pressures on the economy due to lack of demand. Over the period of time, Bank of England has taken measures to keep the interest rates at really low levels in order to ensure that easy credit is available to consumers at relatively low rates. The idea was also to induce the consumption in order to regenerate the demand and increase the economic activity. (Elliott, 2010). However, the continuation of this policy seems to have backfired because of the rapid increase in the inflation in the economy. Bank of England has to maintain a targeted inflation rate of 2% however higher inflation means that the BoE has to take measures to bring it down to the targeted level. This paper will discuss as to what policy options BoE can exercise in order to reduce the inflation and lessen its negative impacts on the economy. Inflation Inflation is considered as a rise in the general price level in an economy over a given period of time. It therefore measures the rate of change of prices over a given period of time and indicates a percentage rate by which prices of goods and services have generally increased during the given period of time. Inflation is therefore also considered as key measure of the cost of living in any economy and offers a great insight into the overall direction of the economy. It is also important to note that the inflation also erodes the purchasing power of money therefore a persistent increase in inflation would mean that purchasing power of money will gradually reduce and the money will buy fewer and fewer goods and services as the inflation increases. (Mankiw, 2002). In order to measure the inflation, consumer price index is used which measures the changes in the prices of a fixed basket of goods and services and compare the new prices with the prices set in base year. The change therefore outlines as to how much inflation has emerged in the economy over the period of time. There are different price indices which can be used to measure the inflation however, consumer price index or CPI is widely used as a measure of inflation in the economy. Other indices include producers’ price index, commodity price index etc and these indices measure different aspects of price change over the give period of time in any economy. Inflation generally can be of two types i.e. cost push and demand pull inflation. Cost push inflation occurs when there is a decrease in the aggregate supply due to the increase in the wage rates as well as increase in the prices of the raw materials. These economic variables therefore can cause the aggregate supply to decrease thus pushing the prices of the goods and services up and therefore increasing the inflation within the economy. Demand pull inflation can occur due to an increase in the aggregate demand and therefore can cause the price level to rise. This could occur mostly due to the increase in the aggregate money supply or the expansionary fiscal policies adapted by the government. Why Inflation Arises? Inflation also tends to occur when the overall aggregate demand for goods and services increases more rapidly than the increase in the aggregate supply of the goods and services. There can be different factors which can actually cause this imbalance between the aggregate supply and demand in the economy. The key reasons as to why this imbalance may occur can due to the increase in the consumption level, an increase in the investment level, expansionary fiscal policies adapted by the government or any adverse supply shocks. These factors can potentially create the imbalances between the two variables however, they may not be more critical in creating inflationary pressures in the economy. (Abel & Bernanke, 2007). One of the key economic variables with the potential to create sustained increase in the inflation is the growth in the money supply. If central bank keeps on increasing the money supply without any restrictions, chances are that the increased level of money supply would end up creating inflation and the prices will tend to increase sharply. (Abel & Bernanke, 2007). The overall costs of inflation often depend upon the expectations about the increase or decrease of inflation in any economy. If the different economic agents can anticipate or expect that the inflation will increase the overall costs can be managed because everyone anticipates the change and thus adjustments are made. It is the unanticipated inflation which can cause serious increase in the costs of inflation to almost all the economic actors. The unexpected inflation has the potential to transfer the wealth from one group to another and therefore can create serious inequalities within the economy. Further, the resources used in ensuring protection against the unexpected inflation can cause further increase in the costs of inflation to the economy. (Abel & Bernanke, 2007). Money Supply and Bank of England Bank of England, in the wake of the current financial crisis, also took the policy initiative of increasing the money supply through both the traditional as well as non- traditional methods. It exercised quantitative easing as one of the non-traditional methods by increasing the money supply artificially within the economy. Initially it announced to increase the money supply through quantitative easing up to the limit of ?200 Billion however; the same was put on hold. (Seager, 2010). Initially the limit was set at ?150 Billion which was started during 2009. During 2009, BoE also set up a ?75 Billion fund to buy back the government issued bonds from the open market thus increasing the money supply within the economy. (Kollewe, 2009). Source: http://www.statistics.gov.uk/cci/nugget.asp?id=192 Through quantitative easing, BoE attempted to allow financial institutions to have access to more money in order to fight the recession. This policy adapted by BoE was perfectly rational given the fact that the industrial economies often tend to use expansionary monetary policy in order to fight with the recessions. This policy adapted by BoE was therefore a perfectly plausible policy initiative in order to cope with the recessionary pressures in the economy due to the negative and slow growth experienced by British economy over the period of time. The period after 2007 was typically more difficult for the economy as the growth rates declined and the overall consumer confidence declined sharply besides financial services sector of the economy faced stiff challenges. Interest Rate Reduction Another traditional method to increase the money supply in the economy is to reduce the interest rates thus increasing the flow of so called easy money in the economy. Since 2008, BoE has started to lower its policy rate and it now stands at 0.5%. This policy or base rate therefore serves as the primary rate in the economy based on which all other interest rates are determined. Due to this reduction in the interest rates, BoE allowed the economy to experience higher money supply. Policy Evaluation Taylor rule is considered as one of the effective tools which can allow the Central Banks to anticipate the changes in the interest rates with the actual divergence in the inflation rates. This rule suggests that the interest rates should be higher when the inflation rate is higher than the target level i.e. BoE has the target inflation rate of 2%. However, when the economy is suppressing, it advocates the use of low interest rates in order to stimulate the growth in the output levels. In situations where economy is facing the stagflation i.e. a situation where the inflation rates are above the target level and the output is below the full employment level, Taylor rule actually prescribes giving the weights to reduce the inflation and increase the output. (Asso, Kahn, & Leeson, 2007). UK is currently in a situation of stagflation where the inflation level is gradually increasing while the output level is not rising. In order to cope with the situation, following policy initiatives can be taken: Increase in the interest rates One of the most effective methods for curbing the inflation is to increase the interest rates and therefore reduce the growth of money supply in the economy. Bank should make efforts to gradually increase the interest rates without hampering the growth prospects within the economy. Considering the delicate current situation, it is really critical that the increase in the interest rates shall be gradual and the expectations of the public shall be built into it. Expected Augmentation Gradually reducing the money supply and therefore reduce the inflation can cause the recession because unemployment level will increase. Philips curve suggest that if reduction in money supply could result into the decrease in inflation, chances are that the unemployment level will rise above the natural rate of unemployment and therefore can cause further recession. In order to avoid this situation, BoE can also actually take another approach in order to balance the unemployment as well as the inflation in the economy. If the expected inflation rate of the public can be brought down as the actual inflation rate in the economy, chances are that the unemployment level will not rise above the natural rate of unemployment. Keynesian approach therefore suggests that the increase in the interest rates should be gradual and should take place over the period of time. (Abel & Bernanke, 2007). Reputation and Credibility It is also important to note that the element of credibility and reputation can also play significant role in allowing BoE to actually initiate the process of inflation reduction. In order to achieve the higher credibility, BoE along with the government therefore will have to take measures to ensure that the steps announced by them will actually be considered credible by the public. Public confidence therefore in the ability of BoE and Government can serve as key ingredients to ensure that any policy initiative can be welcomed by the Public. (Abel & Bernanke, 2007). Conclusion Bank of England is really in a dilemma of stagflation where the inflation is constantly increasing whereas the output level is not. The increase in the inflation rate has been mostly attributed to the expansionary monetary policy adapted by the Bank through quantitative easing as well as the reduction in the interest rates. In order to overcome this situation, BoE need to gradually increase its interest rates while at the same time allowing the lowering of expected inflation. It is also important to note that the BoE must also develop the reputation and credibility for its steps to reduce the inflation. References 1. Abel, A & Bernanke, B (2007). Macroeconomics. 6th. ed. New York: Prentice Hall. 2. Asso, P, Kahn, G & Leeson, R (2007). The Taylor Rule and the transformation of Monetary Policy [online]. [Accessed 5 March 2011]. Available from: . 3. Elliott, L (2010). Bank of England's money pump is all that's keeping economy going [online]. [Accessed 05 March 2011]. Available from: . 4. Kollewe, J (2009). Bank of England cuts rates to 0.5% and starts quantitative easing [online]. [Accessed 03 March 2011]. Available from: . 5. Mankiw, G (2002). Macroeconomics. 5th Revised edition. ed. New York: Worth Publishers Inc. 6. Seager, A (2010). Bank of England halts quantitative easing [online]. [Accessed 03 March 2011]. Available from: . Read More