The UK Forward Guidance Policy Revision - Essay Example

Introductory Economics Contents Contents 2 U.K. Forward Guidance Policy Revision 3 Impact of Changes in Monetary Policy 4 Role of Quantitative Easing9 Reference List 11 U.K. Forward Guidance Policy Revision The fiscal activities in an economy are substantially dependent on monetary policies undertaken by the central bank. In the contemporary era, the central bank is considered as the pivotal institution determining the scope and scale of economic transactions undertaken by a nation. The article claims that the present Governor of the Bank of England, Mark Carney, has recently stated that the bank had overvalued the interest rate policy in the nation (BBC, 2014). Through the Forward Guidance Policy, central bank in a nation tries to match its forecast regarding interest rates with the market expectations of the same in the long run. If interest rates are forecasted to be low in an economy, then it makes productive investors believe that in the long run, cost of borrowing funds would be less. Under such circumstances, the rate of investments made in an economy would increase and level of economic productivity would also rise. Finally, a rise in the domestic product of a nation simply indicates a fall in unemployment rates. The Bank of England initially claimed under the regime of Forward Guidance Policy that it would not increase the lending interest rate above .5% in the long run, until the unemployment level in the country falls to 7% or below (BBC, 2014). Accordingly, such claims made by the Bank had succeeded in lowering the level of volatility in the market as well as enhancing the level of investments made in the country (BBC, 2014). Nonetheless, governor of the bank had mentioned that it was required to revise the Forward Guidance Policy because such forecasts would generate excessive job opportunities in the nation, that would automatically increase the amount of money and hence, demand in the economy; ultimately carving the path of inflation in the long run (Howker and Malik, 2010). The Bank also claimed that in its revised Forward Guidance Policy, it would forecast several macroeconomic factors, apart from unemployment and interest rate. The bank asserted that it would increase the interest rate to 2% to stabilize the unusual growth of employments in the nation. Although Mark Carney claimed that the country would experience high growth from 2.8% to 3.4% in the recent years, he also added that the growth was “neither balanced nor sustainable” and way below the pre-financial crisis levels (BBC, 2014). With reference to such revised estimates for future, the risk adverse attitude of investors in the nation would fall to some extent. They would realize that they had overestimated stability of the economy from the Forward Guidance Policy introduced in August and thus, will become more cautious while taking large loans for investments. This would automatically reduce excessive rise in employment opportunities in the nation. When commoners in the country would find that the aggregate employment opportunities have fallen, they would reduce their spending in the market and accumulate their income in form of savings for future uncertainties (BBC, 2014). Lower spending would imply lower production requirements, which would again generate a downward pressure on the level of employment opportunities in the nation. In this way, the Bank of England has estimated to curb unreliable, excessive growth of employment in the nation in the long run. So, from the above analysis, it can be claimed that public in England have expected monetary policy in U.K. to change soon due to declaration of Forward Guidance Policy revision by Bank of England, which is required for maintaining sustainable interest and unemployment rates in the nation (BBC, 2014). Impact of Changes in Monetary Policy Monetary policies are those undertaken in an economy for manipulating supply of money in the market in a way that would help in enhancing the level of economic growth and stability in a nation. Such policies are often implemented in the economy through changes in interest rates charged on lending and borrowing operations by banking institutions. The monetary policies undertaken in an economy generates prompt and long-lasting impacts on the economic status of a nation by influencing several macroeconomic factors. After emergence of the global financial crisis, monetary authorities in most of the nations have undertaken active policies in order to cut down interest rates in the markets as well as provide reliable forecasts regarding long-term interests in the nations. However, it should be noted that monetary policies undertaken in a nation are either expansionary or non-expansionary in nature. The policies that boost the supply of money in an economy are termed as expansionary polices. These simultaneously reduce the velocity of circulation of money in an economy through non-expansionary policies. According to the Quantity Theory of Money: M * V = P * Q, where M= supply of money in an economy V = velocity of money circulation in an economy P = price level in an economy Q = output or income level (McEachern, 2012) The above equation of Quantity Theory of Money elaborates the positive relationship between income and money supply of an economy. Based on the Quantity Theory Of Money, money demand function can be stated as: Money Demand = L(r -, Y+), where r is the rate of interest in an economy and Y is the level of output or income. On the other hand, supply of money in an economy is determined by the central bank of the nation. Thus, the money supply function can be stated as: Real Supply = M/P, where M is the money supply and P is the aggregate price level in an economy. The money market in equilibrium in an economy explains the condition as follows: M/P = L(r -, Y+). At different rates of interests in an economy, the LM curve is the locus of all money market equilibriums. It is a positively sloped curve, marking the positive relation between rate of interest and output level in an economy (Pindyck and Rubinfeld, 2012). Figure 1: LM Curve (Source: Mankiw and Hakes, 2011) The above graph elaborates an LM curve. At every point on this curve like, A, B, and C, the economy experiences money market equilibrium. As LM curve explains money market equilibrium, commodity market equilibrium is depicted by the IS curve. Figure 2: IS Lm Equilibrium (Source: Mankiw and Hakes, 2011) The IS-LM equilibrium in an economy elaborates the money and commodity market equilibrium. The impact of monetary policy on income, interest rate and price level in an economy can be explained through the IS-LM framework (Brakham and Ward, 1999). Any change in the supply of money in an economy extends to certain alterations in rate of interest in the market. Nevertheless, the interest rate is altered in a pattern that helps to maintain the money market equilibrium at a constant level of income (Pirounakis, 2013). Figure 4: Monetary Policy and Interest Rate Interest Rate M/P1 M/P2 r1 L(r, y) r2 Money Supply and Demand (Source: Author’s Creation) For instance, if supply of money in an economy is increased, then it would surely reduce the rate of interest at a given level of money demand. This will make the LM curve shift rightward. The impact of an expansionary monetary policy on income or output level of an economy can be explained through the IS-LM framework. Figure 6: Monetary Policy and Income LM LM1 r1 r2 Y1 Y2 (Source: Author’s Creation) When the LM curve shifts right due to rise in money supply and fall in interest rate in the IS-LM framework, for a given IS curve (commodity market equilibrium), the level of income would go higher. With the essence of expansionary monetary policy, level of money in the hands of commoners in a nation would increase. This will augment the aggregate demand for goods and services in the market. High demand for products (if exceeds its market supply) would generate rise in price or inflationary situation in an economy (Paloma and McGreal, 2008). Figure 7: Money Supply M/P (Source: Author’s Creation) As denoted by the above graph, the long run real money supply curve must be vertical as supply of money in an economy is always exogenously given. If money supply increases (M) in order to keep the real balance of money (M/P) fixed, then the price (P) level in an economy would also experience a hike (Bernanke, Gertler and Gilchrist, 1996). Role of Quantitative Easing The global financial crisis had generated severe recessionary trails in the economy (Mankiw, 2011). The government of the country experienced high budget deficit and aggregate productivity had also fallen significantly. In order to stimulate the economy, the Bank of England had introduced the policy of Quantitative Easing on 11 March 2009 (Joyce, 2012). It was an unconventional monetary policy undertaken by the bank. Under the regime of this policy, the bank started to purchase worthy and reliable financial assets from commercial banks and financial institutions of the nation. In return, the central bank offered loans to these banking and non-banking financial institutions at less than 1% rate of interest. Since the Bank of England had generated a high demand for worthy financial assets in the nation, this helped to increase prices of these assets in the market as well as lower the yields of government bonds. Asset prices in an economy are inversely related to the rate of interest. After implementation of Quantitative Easing, rate of interests in the market had notably declined due to higher prices of assets. The low rate of interest in the economy raised the level of investments. With rise in scale of investment, the economy could recover from the recessionary trap and increase its productivity (BIS, 2005). A substantial rise in level of productivity of the country created higher demand for labour in the labour market and finally, assisted to augment the extent of employment opportunities in the nation (Tucker, 2010). A higher level of income in the economy was experienced with the essence of increased job incomes. Low yields of government bonds coupled with higher prices facilitated reduction of rate of interests in the economy. Therefore, the policy of Quantitative Easing was basically an unconventional expansionary monetary policy, which was undertaken by the Bank of England so as to stimulate the supply of money in economy, during recession (Muellbauer and Murphy, 2013). The policy had substantially served to relieve the economy from strong negativities associated with the financial crisis. Finally, the bank has now decided to “taper” the policy of Quantitative Easing and has also reduced the level of its bond purchase from the market (Abeles, 2001). Reference List Abeles, T. P., 2001. Impact of Globalization. The Impact zation. On the Horizon, 9(2), pp. 2 – 4. BBC, 2014. Mark Carney adjusts bank interest rate policy. BBC News Business, 12 February. Bernanke, B., Gertler, M. and Gilchrist, S., 1996. The financial accelerator and the flight to quality. The Review of Economics and Statistics, 78(1), pp. 1–15. BIS, 2005. Real estate indicators and financial stability. Monetary and Economic Development, pp. 1-394. Brakham, R. J. and Ward, C. W. R., 1999. Investor sentiment and noise traders: discount to net asset value in listed property companies in the U.K. Journal of Real Estate Research, 18(2), pp. 1-22. Howker, E. and Malik, S., 2010. Jilted Generation: how Britain has bankrupted its youth. London: Icon Books. Joyce, M. A. S., 2012. The Financial Market Impact of Quantitative Easing In The United Kingdom. Charleston: BiblioBazaar. Mankiw, G. N. and Hakes, D. R., 2011. Principles of Macroeconomics. Connecticut: Cengage Learning. Mankiw, G. N., 2011. Principles of Economics. Connecticut: Cengage Learning. McEachern, W. A., 2012. Economics: A Contemporary Introduction, 10th Ed. Connecticut: Cengage Learning. Muellbauer, J. and Murphy, A., 2013. Boom and busts in the UK housing market. The Economic Journal, 107(445), pp. 1701-1727. Paloma, T and McGreal, S., 2008. Measuring price expectations: Evidence from the Spanish housing market. Journal of European Real Estate Research, 2(2), pp. 202-285. Pindyck, R. S. and Rubinfeld, D. L., 2012. Microeconomics. New Jersey: Pearson Education. Pirounakis, G. N., 2013. Real estate economics: A point to point handbook. London: Routledge. Tucker, I. B., 2010. Survey of economics. Connecticut: Cengage Learning. Read More