Tuesday, December 30, 2008

How Effective Is Monetary Policy In Countering Deflation In UK?

In Japan, price level is falling severely from the period of 1998. Inflation is negative for such a long period. The Bank of Japan begins to increase interest rate only in late 2006

Expansionary/ reflationary/loose monetary policy are pursued to prevent the price level from falling down

Monetary policy attempts to influence the movement of AD by manipulating the level of interest rates

Here, the deflation that occurs is likely due to weakening of spending into the real economy. As such, attempts must be made to move AD to the right via interest rates cut

How does monetary policy work to counter deflation?

(1) Consumption.
In theory, cut in interest rates actually create a disincentive for people to save. Also with lower interest rates, more people will find that purchasing items by credit is now cheaper. As such it will fuel spending onto property, cars, plasma TV etc. Meanwhile for people with existing debt, they will find that mortgage interest repayments as a % of their income has shrunk. This means increase in disposable income & more can be spent onto other goods. All these 3 will lead to increase in consumption. AD will shift right, thus preventing the price level from further falling down

(2) Investment. Lower interest rates also encourage more entrepreneurship activities. More firms will be taking up credit financing to enlarge existing operations, to acquire other businesses, buy capital goods, build new factories etc. Their interest to do so increased, as lower interest rates translate to higher return on capital. As I is a component of AD, this will jump-start AD & thereby prevent price level from falling

(3) Export. Lower interest rates will cause pound to depreciate. High net worth individuals, hedge funds, pension funds etc will probably withdraw savings from UK to seek for higher return elsewhere, causing heavy selling of pound. Somehow, cheap pounds will help to boost demand for UK exported goods. As X increase (assuming M constant), this should help to push net export higher, thereby an increase in AD


(1) No implementation lags. MPC had gained independent since May 1997 from Labour government & as such its operation is said to be free from political influence. Also they conduct meetings every first week of the month & interest rate decision is made a day after that. As such it is fast & efficient

(2) Effect lags. Monetary policy may suffer from effect lags. It is said that any effect onto the real economy can only be seen in 18 months time. In other word, the recent interest rate cut may not produce any result at least until June 2010. This is because many people are switching to fixed rate mortgages, especially in the period of early 2000s where interest rates are steadily rising. Therefore their consumption pattern may not change immediately

(3) Consumer confidence more important. Interest rate cut may not produce desirable result, if consumer confidence is falling drastically owing to the property market slump. Japan is a good example. In the period of economic depression, all have been done including driving interest rates to 0%, cutting income tax & explosive government spending up to 194% of their GDP. But none of them work. As cut in interest rates fail to stimulate spending, we call this phenomenon as liquidity trap

(4) Undermining effectiveness of traditional tool. There is a limit into the working of traditional monetary tool. For instance interest rates can’t fall below 0%. In UK, key rates standing at 2% means there is still room for MPC to manipulate the rates. Unfortunately, in US the official rates are now at between 0%-0.25%, which doesn’t make much difference by saying that it stands at 0%. Therefore, we say in US monetary policy has completely lost its effectiveness since rates are so low & it fails to kick-jump the economy

(5) Quantitative easing. There are still other monetary tools that can be pursued by MPC if the rate cut is ineffective. It’s called quantitative easing. This refers to large scale of buy-backs of government debt by BOE. The purpose is actually to increase liquidity in financial system, hoping that banks will eventually resume their operation as usual. This was an option considered by the Japanese government during the period of depression in late 1990s. Although this is said to be possibly contributing to high inflation or hyperinflation, the possibility is remote

(6) Positioning of UK economy. In the current period, very likely there is high spare capacity in the economy. As such any cut in interest rates, in theory, will be able to give a large boost to real GDP without causing much inflationary fear in the future

(7) Banks not co-operating. In the current period, banks are seizing opportunity to rebuild their balance sheet e.g. recoup some of the earlier losses. As such, they are reluctant to pass on the full interest rate cut. For e.g. fall in 1%, only 0.25% will be given to borrowers. As such costs of borrowing remain high & therefore this defeat the objectives of monetary policy. Also costs of interbank lending (LIBOR) remain high & this further tightens the credit crunch

(8) Deflation not necessarily bad. If the falling price level is due to increase in competition, higher level of investment in technology, greater productivity etc then the outcome may not be bad. This is because, as AS curve shifts rightward price level will fall & yet there is an increase in real GDP. Also consumers’ welfare may increase as they are now paying lower price & yet enjoy more goods
(9) Couldn't be targeted to certain sectors. Monetary policy could be argued as a blunt policy tool. Once the decision is being made, it actually affects all sectors of the economy. On the other hand, fiscal policy changes can be targeted to affect certain groups such as means-tested benefits for low income households, reductions in corporation tax only for small-medium size enterprises, investment allowances for businesses to set up in certain region etc


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Lawrence Low said...

Thanks for sharing. A nice piece of article