HOW MONETARY POLICY WORKS

We need to examine how the Bank uses monetary policy, not just to set interest rates but by intervening in the money market on a daily basis to ensure that the rate it has set becomes the equilibrium rate. This then has the longer-term effect on a range of variables, thus the Bank is able to meet its inflation target.

Source '' The Bank of England

The Bank sets a rate of interest at which it lends to banks, this affects the rates at which the banks, building societies and other financial institutions set for their own lenders and indeed savers. When the Bank alters the interest rate it is attempting to influence the level of spending in the economy. The Bank ensures there is a shortage of liquidity and then supplies funds through the repo and discount markets at the chosen rate, this then has a knock on effect throughout the economy. Sloman et al (2007).

We have examined how the MPC set “nominal interest rates”, true rates are set by the market, they are just another price: the price of spending today instead of next year, Harford (2006).

The following is likely to happen in the economy when the Bank reduces rates ''

Saving becomes less attractive to individuals and they are likely to spend more. Borrowing becomes cheaper; individual borrowers then have more disposable income, which they are likely to spend. Over the last decade rates have been at a historically low level, the availability of cheap money has led to increased consumer spending, as result borrowing on credit reached £1.2 TRILLION in the UK.

Firms with bank loans or other borrowings will have less interest to pay; they may well spend on other things. In addition firms invest more because any large investment becomes cheaper to finance. Both of these actions will increase the level of spending either in the UK, increasing domestic demand or by purchasing from abroad and increasing imports.

Financial assets, shares and bonds are also affected by a reduction in interest rates. Some share prices will increase, for example a company with high level of borrowing will save money, make more profit and possibly pay higher dividends. Share prices of companies selling consumer goods may well increase because investors anticipate that consumers with more money will increase demand.
The housing market is likely to be stimulated by lower interest rates. First time buyers find it easier to borrow, homeowners moving up the ladder can afford bigger mortgages, demand for houses increases and prices rise. Even if people don’t move house, they can borrow more by remortgaging because the house has a higher valuation. The extra borrowing is likely to be spent on consumer goods.
If homeowners don’t move house or remortgage they are still likely to spend more money '' simply because of the feel good factor due to rising house prices. In addition they are also less likely invest in any other form of saving as they anticipate that house prices will continue to rise.

It is difficult to predict the how exchange rates will be affected by a reduction in interest rates. If UK rates change unexpectedly and not in line with other countries, UK investment becomes less attractive to overseas investors, resulting in an outflow of money from the UK. Sterling weakens, making the cost of imports higher and reducing demand. The price of exports will decrease and stimulate demand from abroad. However, Weale et al (1989) cautions, that when interpreting movements in exchange rates one must understand that there are two kinds of irrationalities at work; firstly, changes in sentiment tend to be infectious and secondly, speculators may not act in accordance with the normal rules.
My own experience '' at 10a.m. on the Morning of December 6th, I received an e-mail from Barclays Capital '' it said that due to weaker data from the housing and service sector, the Bank was likely to reduce interest rates and as a result the markets had priced in an 80% chance of a rate cut. Sterling was at a four month low against the euro and a one month low against the US dollar. So two hours before the Bank made the announcement, exchange rates had already moved as a reaction to market activity, thereby proving that people act on their expectations.

The increased domestic demand for goods could cause a disequalibrium between the supply and demand of goods and could lead to demand'' pull inflation. These higher costs feed through to producers and then consumers. Employees then demand higher wages because their cost of living has increased, the level of any wage settlement will depend upon the expectations of the future levels of inflation.

If the amount of money spent; grows faster than the output produced, inflation results, The Bank will then try to influence inflation by changing the interest rate. The circular process starts again.
There is a time lag for the effects of interest rate changes to effect spending and saving decisions by individuals and firms. The Bank estimates that the maximum effect on output takes up to one year and may take up to two years to effect consumer prices. Therefore it is likely that despite repeated press comments of a slowdown and even speculation that the US may already be in a recession, it is likely that the Bank will wait a little while before deciding to reduce rates again.

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