Monetary Policy and the Behavior of the MPC - Essay Example

? Monetary Policy and the Behavior of the MPC of the of the Monetary Policy and the Behavior of the MPC Introduction Monetary and fiscal policies remain the two chief instruments of control by the Government on its citizens at a macro level. While monetary policy deals with controlling the demand and supply of money in the economy at any given point of time, so that the level of inflation and unemployment are kept at manageable levels, fiscal policy targets the disposable income through taxation so that spending and production is controlled and the economy does not overheat. The UK is at present moving from a heavily indebted status in 2007 to a manageable one through adopting strict austerity measures, and the present policy of the Government as well as the attitude of the Monetary Policy Committee reflects this fact. This paper will review the policy as stated in the given documents, evaluating whether the stance adopted by the MPC is correct and adequate. It also looks at the mix of fiscal and monetary policy incentives and disincentives to save, spend and invest, and the impact this is having on the UK economy as a whole. The Policy Mandate of the Bank of England The present policy mandate of the Bank of England, the UK’s central bank is dictated by the twin economic objectives of maintaining a high level of employment or low involuntary employment with promoting a high level of production of goods and services with rapid growth (Samuelson & Nordhaus, 2005). Meanwhile the latest available Inflation Report dated February 2011 shows that the Consumer Price Index (CPI) rose between 4 to 5 percent as against a target inflation rate of 2 percent. The main reasons for this were the increase in VAT since December 2010, an unprecedented rise of 15 percent in energy prices and 20 percent in food prices, and a fall of 25 percent in the value of UK Sterling. Meanwhile, unemployment remains at 8 percent and even the unexpected cold wave we have seen last winter has negatively affected productivity and the rate of output in the UK (BOE, Opening Remarks). The most realistic estimates by the Bank of England are that inflation will continue to remain at the 4 percent level till the end of 2011 and then come back to the target of 2 percent being more realistic in the long run. In the process it is expected that exports will grow to the level that it supports monetary policy and exchange rates, bringing the economy back on track and at least out of the present crisis, which by the Governor of the Bank of England’s own admission is the worst we have faced since the Great Depression of the 1930s (BOE, Q&A). The Importance of Central Bank Credibility The central bank of any nation has a key role in setting and controlling the money supply and controlling the rate of inflation in the country (Rosen,2004). The role of Mervyn King, the Governor of the Bank of England is just that and he does it with the help of a nine member Monetary Policy Committee. Of course, the estimates made by the MPC are hardly ever on target explicitly, but at least they give a sense of direction in which the economy is going. The inflation rate is not known to change rapidly- there is a lag between price and output changes and the inflation rate, but at least we have an indication of whether it is going to be higher or lower than previously. What is worrying at present is how to stimulate the economy without raising the rate of inflation. At the same time, the rate of inflation is largely in control in Germany and USA, to name two of the UK’s best trading partners. It has been fortunate for them that their exchange rates have stabilized and had not been so adversely affected as in the UK. The Bank of England and the MPC wait and evaluate the events in the economy before making a decision on increase in Bank Rates, for example. They have to wait for shocks to be absorbed by the economy and allow for these in their estimates (McConnell & Brue, 2005). Being consistently wrong and off the target for key estimates would mean that the Bank of England and the MPC would lose their credulity. Thankfully this has not occurred yet. There is still a healthy interest in the Inflation Reports published quarterly and this interest can also be judged by the bevy of intelligent and seasoned reporters that interview, question and badger Bank of England Governor Mervyn King and his associates at the accompanying conferences and announcement venues. The Current Adequate Fiscal and Monetary Policy Mix for the UK The current mix of fiscal and monetary policy for the UK is contractionary. The Bank Rate has been maintained at 0.5 percent since November 2010. By the same token, the stock of Central Bank Reserves has been kept at ?200 billion. These would have been sufficient enough to maintain the rate of inflation at around 2 percent, but extraneous factors such as rise in food and energy prices have resulted in raising the CPI to between 4 and 5 percent. It will take till the end of 2011 for conditions to stabilize and inflation to match the desired target of 2 percent. Market demand for housing has also declined, as credit opportunities have dried up. Higher energy and food prices have impacted all of us, and dampened consumer appetites. Both broad money and GDP has declined over the quarter. The outlook for growth remains uncertain, and much would depend on the efforts of private sector investment and the pace at which the world economies rebound after the effects of the recession. Consumer spending would of course be impacted by VAT as well (BOE, Feb 2011 Inflation Report). The Conduct of Monetary Policy at Very Low Interest Rate Levels The lessons of 2007 have been learned. By maintaining a low Bank Rate, low rate of credit expansion and rise in food and fuel prices and the increase in VAT affecting consumer spending, the Bank of England and the MPC hopes to control inflation and unemployment at present levels. We use IS-LM analysis to see the effect of fiscal policy measures and monetary policy measures on the Interest Rate and national income assuming the money market is in equilibrium. While Keynesian economists state that interest rates have no impact on investment outlook, the Monetarists say the opposite (Gruber, 2009). The NAIRU is the lowest unemployment rate that can be sustained without an increase in inflation. However, inflation is only indirectly controlled through interest rates, the real determinant is the supply of money in the economy and if this is shrinking, we are heading towards a liquidity trap. This is what the Bank of England and the MPC have to guard against. The Interplay between the Open Economy and Monetary Policy Countries having open economies have far more opportunities to save and invest, because their monetary policies are less restrictive, and they can invest in assets of many countries through the commodity, metals and foreign exchange markets. Countries with a closed economy such as Myanmar have restricted investment opportunities and must depend on domestic saving for investment in economic growth. However, open economies must watch out for adverse fluctuations in exchange rates and deprecation in currency value, which the UK has unfortunately faced. The PC-IS-MR Equation The PC-IS-MR equation is used to explain how central banks control inflation using monetary policy. The PC-IS-MR equation supersedes the old IS-LM approach in Keynesian economics and gives a better and more realistic explanation of the relationship between interest rates, inflation and monetary policy. Central banks today more realistically seek to control the rate of inflation in an economy. They use the nominal interest rate as a policy instrument. It is assumed that the Central Bank acts as and when needed to stabilize the rate of inflation around a targeted level, and output around the natural rate of employment. Based upon past research, it appears that it takes one year for monetary policy to affect output and another year for output to affect the level of inflation. So the lag between a monetary policy change and effect on the inflation rate is two years. The Central Bank can set the nominal interest rate in the short term. If the rate of interest is increased, consumption will reduce and real GDP will also come down. Investment will not be forthcoming, and this will result in a reduction in exports and increase in imports. The IS curve shows an inverse relationship between rate of interest r and real GDP y. If it knows the relationship between r and y and the shape of the IS curve, the Central Bank can adjust r to control y. Given the inflation rate of the last period, the Philips Curve shows the inflation and output deficit that needs to be met in order to reduce inflation to the desired target levels. The Central Bank must increase the interest rates to reduce output and create unemployment which automatically has an effect on the rate of inflation. As income falls, inflation rate falls with it until the target level has been reached. Barro-Gordon Model The Barro–Gordon model indicates that the Government has the power to manipulate which leads to inflationary bias. Their model assumes that a country will try to maintain the unemployment rate in the economy below its natural level. This will create inflation in wages above their natural level. This ultimately results in an overall rate of inflation that is higher than the natural rate of inflation. Some economists have suggested that inflationary bias does exist when monetary and fiscal policies are discretionary rather than rule-based. Others have maintained that an inflationary bias will exist even when policies are based on rules, and policy makers do not have the goal of a lower than natural rate of employment. Several ideas have been put forth to prevent the dangers of inflationary bias. For instance, it has been emphasized that nations should employ central bankers having a conservative outlook. It is also more appreciable that countries should create desired inflationary targets. If this inflation rate is constantly exceeded, the central banker should be replaced. References Bank of England, Quarterly Inflation Report Q&A, 16th February 2011. Accessed on 28 Apr 2011 at http://www.bankofengland.co.uk/publications/inflationreport/conf110216.pdf Bank of England, Inflation Report, February 2011. Accessed on 28 Apr 2011 at http://www.bankofengland.co.uk/publications/inflationreport/irlatest.htm Gruber, J. (2009). Public Finance and Public Policy, 3rd ed. Worth Publishers. McConnell, C. & Brue, S. (2005). Economics, 16th International Edition. McGraw Hill. Opening Remarks by the Governor of the Bank of England at the Inflation Report Press Conference, Wednesday 16 February 2011. Accessed on 28 Apr 2011 at http://www.bankofengland.co.uk/publications/inflationreport/irspnote160211.pdf Rosen, H.S. (2004). Public Finance, 7th ed. McGraw Hill/ Irwin. Samuelson, P. & Nordhaus, W. (2005). Economics, 18th Ed. McGraw Hill. Read More