Monetary Policy Economics

May 23, 2017

Monetary Policy Economics

Monetary Policy Economics

What is economic policy, and how does it work?

In economics, monetary policy involves altering base interest rates, rates that ultimately determine all other interest rates in the economy; or altering the quantity of money in the economy.

Many economists argue that altering exchange rates is a form of monetary policy, given that interest rates and exchange rates are closely related.

Base interest rates

The Bank of England (BoE) is the central bank for Great Britain (which includes England). The BoE is primarily focused on maintaining price stability and supporting the British government’s policy, which is aimed at economic growth.

The 2 most important issues that the British central bank deals with a monetary and financial stability: criteria for monetary stability are stable prices and confidence in the currency. In order to maintain stable prices it is important that price rises match the government's inflation targets (currently 2%). A low rate of inflation results in a stable economy and preservation of the value of the inhabitants’ money.

As a tool the BOE uses the Bank of England base rate (BOEBR), now called the Official Bank Rate.

Exchange rates

The exchange rate of an economy affects aggregate demand through its effect on export and import prices, and policy makers may exploit this connection.

Deliberately altering exchange rates to influence the macro-economic environment may be regarded as a type of monetary policy. Changes in exchanges rates initially work their way into an economy via their effect on prices.

For example, if £1 exchanges for $1.50 on the foreign exchange market, a UK product selling for £10 in the UK will sell for $15 in New York. If the exchange rate now appreciates, so that £1 buys $1.60, the UK product in New York will now sell for $16. Assuming that demand in New York is price inelastic, this is good news for UK exporters because revenue in USDs will rise. However, if demand is elastic in New York, the effect of the appreciation of the Pound would be damaging to UK exporters.

If the UK also imports goods from the USA, the rise in the exchange rate would mean that a $10 US product is now cheaper in London, falling from £6.67p to £6.25p. Importers do relatively well from the appreciation of the pound, in that the cost of imported raw materials or finished goods falls.

Therefore, whenever the exchange rate changes there will be a double effect, on both import and export prices. Changes in import and export prices will lead to changes in import and export volumes, causing changes in import spending and export revenue.

Exchange rates can be manipulated so that they deviate from their natural equilibrium rate. To stimulate exports, rates would be held down, and to reduce inflationary pressure rates would be kept up. While the Bank of England does not specifically target the exchange rate, the Monetary Policy Committee (MPC) will take exchange rates into account. Clearly, the MPC would prefer a relatively high rate, as this reduces the price of imports and works against inflationary pressure. However, the MPC must keep an eye on export competitiveness, and, if rates rise excessively, UK exports will become uncompetitive.

How exchange rates are manipulated

Exchange rates can be manipulated by buying or selling currencies on the foreign exchange market. To raise the value of the pound the Bank of England buys pounds, and to lower the value, it sells pounds. Rates can also be manipulated through interest rates, which affect the demand and supply of Sterling via their effect on inflows of hot money. Altering exchange rates is commonly regarded as a type of monetary policy.

Effects of a reduction in the exchange rate

Assuming the economy has an output gap, a reduction in the exchange rate will reduce export prices, and, assuming demand is elastic, export revenue will increase.

A fall in the exchange rate will also raise import prices, and assuming elasticity of demand, import spending will fall. The combined effect is an increase in AD and an improvement in the UK balance of payments.

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