How the Bank of England Tries to Manage Inflation - Essay Example

? Explain how the Bank of England tries to manage inflation and discuss whether the Quantitative Easing Programme may cause higher inflation in future. Name Tutor Institution Subject code Date of submission Applied economics Introduction The Bank of England is the central bank of the United Kingdom established in 1694 and nationalized on the 1st of March 1946. The bank obtained operational independence to set the UK monetary policy in the year 1997. In April 2013, key operational changes were enacted on the bank since the financial crisis displayed the necessity for a novel approach to financial regulation (Conaghan, 2012). An independent Monetary Policy Committee was launched in 2012 as a subsidiary of the bank to take relevant action in order to eliminate or reduce operational risks with a mission of leveraging and increasing the resilience of the UK financial system (Buckley & Desai, 2011). The committee is also charged with supporting the economic policy of the government. Managing inflation Types of inflation Demand-Pull Inflation In demand-pull inflation, inflation is solely caused by increases in aggregate demand. This inflation develops when the household, government, business and foreign sectors together try to purchase more output than the economy is able to produce. Demand pull inflation results when aggregate demand increases beyond aggregate supply causing shortages in the economy. This type of inflation is can be sustained with an increase in the monetary base (Buckley & Desai, 2011). Cost-Push Inflation In, cost-push inflation, inflation results from decreases in aggregate supply due to increases in cost of production. This type of inflation arises when the cost of using labor, capital, land, or entrepreneurship rises. This means that the production possibilities edge is reducing in size closer to the origin, causing it to bump down against the aggregate demand. The eventual result is inflation. The aggregate supply reduces to less than aggregate demand creating shortages in the economy. As with any market shortage, the price level rises resulting in inflation. Cost-push inflation can only be sustained if the economy has more money available (Buckley & Desai, 2011). Transmission mechanism: excess monetary growth creates surplus demand and a higher price level. Expansion of fiscal and monetary base cause excess demand and as a result, inflation increases. One of the key responsibilities of the bank of England is maintaining monetary stability. This means low inflation, stable prices and confidence in the UK currency. Price stability is defined by the inflation target set by the government, which the bank aims to meet by the decisions taken by the Monetary Policy Committee. The Monetary Policy Committee is a committee that consists of nine experts who meet every month at the bank to discuss and review the performance of the economy and decides on the most effective way to set the monetary policy to achieve the rate of inflation of 2% set by the government (2012). This committee votes on the bank rate at its meetings and decides whether it is wise to employ quantitative easing or not, and if so, how much money should be injected into the economy. The monetary policy committee makes its decision independently without the intervention of the government (Toporowski, 2012). The principal aim of the bank is to protect the value of the currency based on what it is able to buy-an increase in prices implies inflation, which lowers the value of the currency. The monetary policy is created to achieve this aim and developing a structure for non-inflationary economic growth. The monetary policy of the bank of England controls inflation by influencing the interest rate at which money is lent and through quantitative easing (QE)-injecting money directly into the economy by buying assets. This implies that the banks mechanisms of managing inflation through monetary policy budges towards the quantity of money availed in the economy rather than the interest rate at which the bank borrows or lends money to private banks (Smith, 2003). Low inflation is a significant element in efforts to encourage lasting stability in the economy and maintaining confidence in the currency while stability of interest rates is a requirement for accomplishing a broader economic objective of employment and sustainable growth. How Quantitative Easing works: The Bank of England targets to keep inflation at a rate of 2% that has been set by the government. Maintaining low and stable inflation is critical to a flourishing and rich economy. Unstable inflation rates are costly to companies and households because they make it difficult to monitor how the prices of individual products are varying compared to one another (Klyuev et al, 2009). The improbability regarding future prices of goods make it more intricate for companies to get into long-term contracts. The bank employs borrowing and lending interest rates to manage inflation. The monetary committee lays down an interest rate at which financial institutions can borrow money from the bank. This is known as the bank rate. It influences many other rates available to borrowers and savers thus variations in bank rate affect the expenditure of companies and their customers and, eventually, the rate of inflation. A high rate of inflation has historically been associated with higher instability as compared to low inflation (Publishing & Duignan, 2013). The bank has to look ahead when settling on the suitable monetary policy since it can take up to two years for changes in bank rates to have their full influence on the rate of inflation. The bank increases the bank rate to decrease spending and reduce inflation in situations where the rate of inflation is likely to rise above the 2% target (Scott, 2001). Similarly, if the rate of inflation is tending to fall below the target, the bank lowers the bank rate to improve inflation and spending. When the bank identifies a potential risk of very low inflation, it slashes the bank rate by reducing the price of central bank money. The bank lowers the bank rates but interest rates cannot drop below zero percent. Therefore, when the bank rate is almost at zero percent, the bank employs the quantitative easing technique to increase the quantity of money. It injects cash directly into the economy, not by printing more bank notes and giving it out, but through the creation of money used to purchase of assets such as high-quality debts and government bonds from the private sector institutions like insurance companies, banks, pension funds of non-financial firms. The bank then credits the bank accounts of the sellers (Great Britain, 2012). . As a result, the institutions gain more money in their bank accounts whereas their banks hold corresponding claims against the bank of England-known to as reserves. This results in more money in the broader economy. The bank of England’s buying of both corporate and government bonds raises the demand for such assets, increasing their prices. This provides an easy way for companies to raise finance (Smith, 2003). In a modern economy, money constitutes both cash and bank deposits. The amount of money in the economy normally grows every year and increases too fast during certain periods. Excess money in the economy can result into too much inflation. However, a different problem occurs in case the economy weakens sharply-there is too little money in circulation. In other words, the supply of money needs to maintain a steady growth rate to sustain the pace with the expanding economy and to guarantee that rate of inflation stays close to the government target of 2% (Gillespie & Gillespie, 2001). Bank of England’s purchase of private sector debt can help to unblock corporate credit markets in situations of the financial crisis by guaranteeing players in the market of the availability of a ready buyer should they be prepared to sell. This helps to bring down the price of borrowing, making it less costly for companies to raise money which they can reinvest in their business (Davidson, 2010). To determine the effectiveness of the asset purchases in quantitative easing, the Monetary Policy Committee monitors what the sellers of the assets are using the money they receive for and what impact it is having on the rate of inflation and spending. The Monetary Policy Committee monitors the costs and ease of borrowing for households and companies to evaluate whether credit is really becoming broadly available and cheaper. It also monitors the bank lending rates and flow of cash in the economy. The success of quantitative easing depends on the extent to which the money injected into the economy boosts spending by households and companies therefore helping to ensure inflation in controlled (Chadha & Holly, 2012). To ensure inflation does not rise above the 2% target, bank of England through the monetary policy committee puts downward pressure on inflation and spending by increasing bank rate and taking out the additional money through the sale of previously purchased assets (Taylor, 2011). Will the Quantitative Easing Programme cause higher inflation in future? Injecting money directly into the economy can have a number of impacts. The private institutions that receive the additional money may go out and spend it thus boosting growth. On the other hand, they may purchase other assets instead, such as company bond or shares. This will result in an increase of the price of those assets, benefiting the owners of the assets either through pension funds or directly (Labonte & Makinen, 2006). The asset owners may go out and increase their spending while the higher cost of assets indicate lower yields, which causes a drop in the cost of borrowing for households and businesses. This offers a higher boost to spending. Additionally, banks will be in a situation where they hold more reserves that might direct them to increase their lending to customers and businesses. Consequently, borrowing and spending increases. If the banks mind their financial well-being, they are likely to keep the extra reserves without increasing lending. This is why the Bank of England purchases most of its assets from the wider economy rather than banks (Smith, 2003). The expansion of the monetary base through the quantitative easing programme is on its own unlikely to propel higher inflation. However, quantitative easing has the potential to increase inflation significantly in the near future when combined with a rise in the rate at which money circulates in the economy. While inflation anticipations remain centered on the target inflation rate of 2%, propelled by the opinion that current QE conditions are temporary, and confidence in the Monetary Policy Committee to successfully reverse the policy, the reoccurrence of wage-price spiral experienced in the 1970s due to inflation (Smith, 2003). Errors in monetary policy decisions remain a crucial risk. The Monetary Policy Committee has a concrete theoretical understanding of the proper time to withdraw the expansion of the economy monetary base. Practically, knowledge of the economy is complicated, and policies rarely turn out to be effective as the theory foresees. Additionally, the prospective for the financial crisis to increase inflation in terms of higher taxes or greater resilience of missed targets is a promising threat. The potential for quantitative easing to inflation in the future is highly unlikely (2010). First, quantitative easing does not necessarily lead to a high increase in domestic money supply; the assets purchased do not directly constitute the money supply in the economy. In actual effect, they only represent a small portion of the overall money supply and on lead to expansion of the bank of England’s balance sheet, which has virtually no relationship with changes in wider measures of the money supply. In a highly developed economy such as the UK, the money supply contracts and expands as a function of the contraction and expansion of credit (Piros & Pinto, 2013). For other measures of the money supply to increase significantly, a net expansion of credit in the overall economy is necessary. However, a considerable expansion of credit requires particular conditions to be met. Such conditions include a substantial increase in demand for new credit and banks’ willingness to expand their credit portfolio by making considerable amounts of new net loans (Heffernan, 2005). Since neither of these conditions exists, quantitative easing is unlikely to create an expansion of the money supply, but simply causes an increase in the monetary base. An increase in the monetary base will not cause a considerable rise in the overall domestic money supply without substantial expansion of credit in the local economy (p. 21). Secondly, increase in money supply does not essentially lead to inflation. For instance, assuming that the quantitative easing is implemented in a way and on a scale that it actually causes a substantial increase in the other measures of the money supply, which is highly unlikely, there would not be an increase in inflation unless the expansion caused in the other measures of the money supply were extremely high (2012). Numerous studies have demonstrated properly that in highly developed economies like the UK, the money supply has little or no direct link to inflation regardless of the scale. Some studies indicate a weak positive correlation while others show no significant correlation; very few studies display negative correlations (Friedman & Woodford, 2011). Nothing can be properly defined with regard to causation. Conclusion Usually, we think of measures of the money supply in a well developed economy as partial and indirect indicators of the valuable demand for services and products in the economy. This is because lack of demand for goods and services causes a shortage of new money creation or net credit creation. In a similar way, the demand for credit, goods and services will be limited if there’s no expansion of the money supply. The supply of money in both enabled by and enables the demand for products and services in the economy (Tavidze, A. (2007). Therefore, if we think of the money supply as a direct or partial indicator of the demand for products and services, it is clear that the rate of change of this variable can offer a hint about the potential of higher inflation in the future. If all factors remain constant if the demand for products and services rises while the total supply remains constant, then prices will increase until total demand and supply become equal. Bibliography Taylor, C. T. (2011). A macroeconomic regime for the 21st century: towards a new economic order. Abingdon, Oxon: Routledge. Conaghan, D. (2012). The bank: inside the Bank of England. London, Biteback. Buckley, G., & Desai, S. (2011). What you need to know about economics. Chichester, West Sussex, Capstone. Davidson, A. (2010). How the city really works: the definitive guide to money and investing in London's square mile. London, Kogan Page. Chadha, J., & Holly, S. (2012). Interest rates, prices and liquidity: lessons from the financial crisis. 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