Note 2--monetary policy

Monetary policy is the process operated by the central bank to use money supply,exchange rate and interest rate to control the amount of people's savings and borrowings.For example,if the interest rate is increased,people will save more in the bank instead of consuming.


In this policy,interest rate is the most effective means for that the change of it will affect the money supply and exchange rate as well. It is just like when the interest rate rises,the exchange rate will change in the same direction because foreign people feel confident of the country that they will choose to save their money in the country's bank and the pound will have more power. Besides,the increasing interests paid by the borrowers and the money savings can increase the money supply.


Therefore,interest rate is always used to achieve the economic objectives. In order to increase economic growth and solve the problems of unemployment or balance of payments deficit,the bank will reduce interest rate to encourage the consumption and investment. However,if they want to reduce inflation or enhance their money supply to operate,they have to increase the interest rate but then it will create the problem of unemployment and deficit again. So,we can always see a conflict between them and the bank have to trade-off according to different situations. The diagram below can show the relationship.

There is a very important point that interest rate is always related to housing market like the mortgage which is essential for the consumers. If the interest rate is high,the cost of mortgage will rise and the demand for the houses will be reduced. Consequently,the housing market will experience the low growth.

What's more?
When we consider whether to increase or decrease the interest rate,we should think about the signals from the housing market like the price of houses and inflation overseas or domestic and exchange rate as well.

In a conclusion,the aim of the monetary policy is to provide the price stability and support the economic policy by affecting:
1)Capital investment
2)Consumption and for credit card
3)Business and consumer confidence
4)Exchange rate

However,we should also know the drawbacks of the monetary policy.
1)Because the bank in England always forecast the future economic situation and then make decisions,sometimes the information is not so accurate. Therefore,there is a risk existing.
2)A central bank's ability to change the interest rate is limited.
3)It will take a long time for the economy to react because the consumers should observe the change for a period of time and build up their confidence.
4)If the interest rate is considerably low,to continue reducing interest rate to stimulate consumption will not make any difference to the economy.