To Understand the Monetary Policy we need to understand the concept of ‘money’ What is money? Money is best defined by the two main functions it performs:
- Medium of exchange; e.g. buying a good
- Store of value or wealth;
The two biggest forms of money; Cash and Bank Deposits – Cash is said to be a small change of monetary compared to Bank Deposits.
Background of Monetary Policy:
Before the current monetary policy there was the belief of Monetarism so it was monetarist( Late 70s to Mid 80s). They were called this because they believed that inflation caused by prior excess growth of the money supply( quantity theory of money). They said for inflation to decrease it must have the money supply in strict control. These policies did not work and it had stopped being monetarist after mid 1980s.
However after this it was at 1992 when today’s monetary policy took its place to control inflation and was taken hold plus modified in 1997 by the New Labour government. The MPC was also made independent by this party and would lower or raise interest rates to meet its target.
Interest Rate : Interest Rate is just basically the price paid to borrow money or the reward for lending money. Bank of England’s interest rate is called the Bank Rate as when the bank rate is changed the interest rates for these banks and other financial institution would change aswell- ‘announcement effect.’
As said its aim is to help the country meet its 2% target however over the recent years it has been also used to help stimulate demand due to the recession in 2008.
However it is said that this policy is not always the best as over the years there has been an over reliance of it and the consequences had shown in the 2008 recession where interest rates were put as low as 0.5% to attract more borrowers( therefore spenders) but there is just no use.- LIQUIDITY TRAP.
So another policy had been installed for the monetary policy that is Quantitative Easing. This is just the production of electronic money for the public in order to increase spending. This was due to the credit crunch where due to the lack of capital assets, banks has to restrict its lending. However what happens if the banks have more money? This is where QE comes into place where the banks who normally get their capital assets by buying up gilts from the bond market, have them bought by the government. This money from the government is pumped into banks hoping they will give money to the public to spend.
However that is not the case as when QE1 had taken place the banks had received electronic money but they just simply used that money to help them correct their capital problems. Therefore there was no use and after that it was ceased until October 2011 when an extra £75 billion (QE2) had been pumped in.
This is just a brief outline of the Monetary Policy
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