Factors Influencing the Monetary Policy - Research Paper Example

Factors Influencing the Monetary Policy A Review: The purpose of this study is to come out with the factors that are generally considered before taking any decision on monetary policy. The analysis also deals with determining the economic factors which play a major role in establishing the monetary policy. There is also an analysis of Base-Rate decision. Any government has the power to regulate the economy of the country and not only does it regulate the economy, it has a vital role to ensure that the economic condition remains stable. It is the responsibility of the government to ensure that all the aspects of economy maintain a stable level so that the country can grow and expand. Government regulates many things in an economy including inflation, exports and imports, prices of many vital commodities, and many important economic aspects. Government of England has entrusted the job of determining the monetary policy, in the hands of Bank of England. Bank of England looks into many other big issues. One of the most important issues is that of ensuring monetary stability in the economy, which can be achieved through a combination of stable prices of goods and services across the economy coupled with a low inflation level and level of confidence of the investors in the currency of the country. The Bank comes out with the monetary policy in order to ensure a certain key objectives like, delivering price stability with a low inflation level coupled with an objective to support the Government's economic objectives of growth and employment. Price stability is taken care of, by the Government's usual inflation target of 2%. There is a need to contemplate the crucial and critical role played by price stability in achieving the aforesaid economic stability, and in providing just the right conditions for a sustainable and longer living growth in output and employment. Chancellor of the Exchequer announces the Government's inflation target every year in the annual Budget statement. Though The 1998 Bank of England Act enables it to set interest rates independently, however, The Bank does hold accountability to the parliament and the wider public, which can not be refrained from. The legislation provides the government the power to instruct the bank on the interest rates issues for a limited period of time during emergency, for the sake of national interests. (How Monetary Policy Works) The inflation target of 2% depicts the target in terms of an annual rate of inflation based on the Consumer Prices Index (CPI). The government's intention is definitely not to achieve the lowest possible inflation rate, as a low inflation is supposed to be equally bad as a high one and for that matter inflation below the target of 2% is judged to be as worse as inflation above the predefined target. The inflation target is therefore very symmetrical. (How Monetary Policy Works) If the Bank misses the target just by a margin of more than 1 percentage points on any side, be it up or down, the Governor of the Bank is required to write an open letter to the Chancellor explaining all the reasons as to why it happened and why inflation increased or fell to such an extent and what are the proposals to ensure that inflation comes back to the target and is retained, however, A target of 2% does in no way mean that inflation will be held at this rate constantly. That would be neither possible nor in any way desirable. Interest rates would be changing all the times, causing unnecessary volatility in the economy. Even then it would neither be possible nor feasible to keep inflation at any predetermined level, say 2% in each and every month continuously. Instead, the committee aims to set interest rates so that inflation can be brought back to target within a reasonable and imaginable span of time without creating undue instability and volatility in the economy. The Committee has its own way of functioning and it entrusts the job of taking all interest rate decision with a nine member committee. The committee's predominantly focuses on meeting the inflation target by setting an interest rate. The level of interest rate is decided by the committee, The Monetary Policy Committee (MPC). The MPC consists of nine members as discussed earlier. Five of these members are from the Bank of England and four external members are generally appointed by the Chancellor. MPC is chaired by the Governor of the Bank of England. It meets once in a month for a two-day meeting, on the Wednesday and Thursday. Decisions are made by a vote of the Committee a person a vote basis. (How Monetary Policy Works) Now, to have a look on how the government monitors the price related regulations to keep a check on inflation, we can consider a small example of the regulation on house and property prices. To take any decisions related to interest rates keeping in mind the ongoing inflation rate, the Bank must be thorough with the booming property prices and must take steps to ensure that the prices are not artificial. Government intervenes through its central bank to regulate the prices of many commodities, similarly it also regulates the prices of houses like any other important commodity. Bank of England has the responsibility to keep a check on asset prices including the prices of houses. There can be a number of reasons why the prices of houses shoot up, like the simple rule of demand and supply has a definite impact. We can divide the demand and supply conditions into two parts, first when it is a sellers market and second when it is a buyers market. (Demand and Supply for Housing). In a sellers market there is more demand and scarce supply, which makes it a fine proposition for sellers, as they can wait for their prices to come. In a buyers market, however, the demand is less and property available in the location is more. This phenomenon gives rise to a buyers market, as they can in such a scenario, wait for their prices to come, needless to say that these prices are far too low than the actual prices. (Demand and Supply for Housing). Other reasons behind a change in property prices can be Mortgages. A mortgage is the money borrowed to buy a house, as for most people buying a house is not easy. Over the years mortgage market has picked up greatly and the current scenario is totally different from the one that existed in the beginning. Mortgages were supplied only by the building societies. Building societies were non-profit institutions and encouraged only the members for the grant of loans, so the people who were members and had contributed to an extent for a considerable period of time got loans easily and account with building societies became the only means to get mortgages. Soon these societies had to compete with the banks and other financial institutions specialized in granting housing loans. This price war resulted in a greater demand for owner occupied houses and consequently the demand for houses grew stronger, resulting in a substantial increase in price. (The UK Housing Market - Factors Influencing the Housing Market: Mortgages) Besides the above-mentioned factor of mortgages there are other factors like stamp duty and planning that affect the market for housing. Mortgage interest relief at source (MIRAS) was a tax concession to owning a house. It reduced the house owner's liability to income tax as the money spent on the interest on mortgage was considered to be tax-free. This made borrowings cheaper and as a result there was a huge demand for housing and the prices shot up. With the introduction of MIRAS in 1990 many people were exempted from stamp duty. (The UK Housing Market - Factors Influencing the Housing Market: Stamp Duty and Planning) The bank has a monetary policy and uses the same to regulate mechanism of the economy and deal with such erratic swings in the prices of property. Like when it decides to change the interest rate, the government is trying to check the overall expenditure of the economy. A change in interest rates is mostly used to contain inflation, which is the result of lavish expenditure by the country. The bank sets a fixed interest rate at which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. The point to be noted here is that, this interest rate set by the Bank of England is so effective and powerful that it chips in greatly to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices through out the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It is note that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets and similarly high interest rates boost up the savings. Lower interest rates make asset and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates, as an increase in the interest rate in UK will yield better returns to the investors compared to their overseas ventures. This phenomenon usually makes sterling assets attractive, which pushes up the value of the currency vis a vis other currencies, and a stronger pound sterling would mean less money would be shed on imports and less quantity of exports will take place as there will a lesser demand for products made in UK because of the currency being strong. It is interesting to have a look at the process of how the bank sets interest rates. The primary step in this direction starts with the estimates of the money flow that takes place between the government and the bank, and the bank and commercial banks. The Bank of England makes sure to rectify all the imbalances, which arise along the path on a daily basis. There can be two phases to the money flow that takes place between the system, first, when more money flows from banks to the government and second, when more money flows from government to the banks. In first case, Bank of England's liquid assets come down, which affects the short-term instruments of money market. And in the second case the market finds itself with a cash surplus. The Bank of England is the bank of the government as well as the bank of all the financial institutions and commercial banks, so it chooses the interest rates for the funds to be provided each day, and this interest rate is passed through the financial system, which influences the interest rates of the country. (How Monetary Policy Works). A detailed diagram given below will help to gain a better insight into the concept. The above diagram explains the concept of system regulation. It shows that the official rate, which is set by the Bank of England, influences many parts of an economy such as market rates, asset prices including the house prices, expectations, and exchange rate. This gives rise to demand, which is the sum total of domestic plus external demand, which in turn gives rise to inflationary pressure resulting in inflation, another important point shown, which deserves a mention is the relationship between the exchange rate and import prices, or the price paid for imports. As explained above, the stronger the exchange rate the lesser the price paid for imports and the weaker the currency the higher the price paid for imports. (How Monetary Policy Works) Before going on to make any base rate recommendation, we must understand what base rates are. Base rate is the rate at which the bank lends money to other financial institutions. These institutions then lend this money to other institutions and corporates and public. Base rate decision would predominantly depend upon the inflation prevailing in the economy. If the base rate is left unchanged and the inflation keeps scaling up higher then the money market and fixed income securities will suffer a set back and the people on the street will run towards more risky investments that could fetch them higher returns, as a result there will be a sharp upsurge in the prices of riskier assets like the real estate and shares. Also, in this way people will be able to raise money at lower rates and invest the same money elsewhere. Any increases in oil prices is expected to feed through into inflation over the next few years, and the gap between the value of imports and exports is growing to record levels, prompting expectations of a decline in the value of sterling, which is a welcome sign for the exporters but will hit the importers, as they will have to shell out more money for importing their raw materials leading to a further increase in inflation. Any decision is taken after considering the condition of the whole economy and all sections of the society at large and there are several other methods to tackle the prices of properties, but it will always be better to increase the rates at a slower but steady pace, rather than giving a monetary shock. Rising Inflation, if not tackled properly and at the right time may create a cycle, wherein the inflation keeps rising due to no change in interest rates. Keeping all the above things in mind, the best strategy will be to wait and watch, and if the inflation remains unstoppable, then a gradual increase in interest rates can be contemplated. Works Cited "Demand and Supply for Housing" tutor2u. 19 Nov. 2006. tutor2u. http://www.tutor2u.net/economics/content/topics/housing/housing_demand_supply.htm "How Monetary Policy Works" bankofengland. 19 Nov .2006. Bank of England. http://www.bankofengland.co.uk/monetarypolicy/how.htm "The UK Housing Market - Factors Influencing the Housing Market: Mortgages" 19 Nov .2006. bized. biz/ed. < http://www.bized.ac.uk/current/research/2004_05/090505e.htm> "The UK Housing Market - Factors Influencing the Housing Market: Stamp Duty and Planning" 15 Apr.2006. bized. biz/ed. < http://www.bized.ac.uk/current/research/2004_05/090505e.htm> Read More