Saturday, September 27, 2008

How Effective Is Monetary Policy In Achieving Higher Economic Growth?

How monetary policy works?

Definition: Monetary policy is the manipulation of interest rates & money supply to influence the movement of AD & overall level of economic activity

By lowering interest rates:

(1) Consumption will increase. Lower interest rates means cheaper to borrow & finance items on credit like houses, cars etc. Those with existing loan pay lesser to the bank on monthly basis & found that they actually have more money to spend now. Lastly, low interest rates may discourage people to save. These 3 factors contribute significantly to consumption spending. AD will shift rightward, thus increasing the real GDP. In fact, UK economy is consumption driven with C standing at 66% of its GDP

(2) Investment will increase. Just like households, firms will find that financing capital goods like machineries & buildings is now cheaper. They will be encouraged to spend onto these. As investment spending is a component of AD, AD will increase thus achieving higher real GDP

(3) Falling imports but rising exports. Value of UK currency can be manipulated by interest rates. By slashing rates, wealthy foreigners & international fund managers will pull their monies out from UK. This may result in heavy selling of pound, thus causing it to depreciate against other currencies. However, as pound falls, UK’s trade partner will find it relatively cheap to buy from UK. Exports increase. On the other hand, weakening pound translates fall in purchasing power for the Britons. Imports fall. Overall effect will be an increase in net exports. AD moves rightward & higher real GDP can be obtained


1. Unlike fiscal policy, monetary policy does not suffer from implementation lags. Members of MPC will hold meeting on monthly basis & thus decision can be executed immediately. For fiscal policy, often a remedial measure has to go through various debates & many other red-tapes before being instituted. By the time it’s put into action, very likely the economy has corrected itself & therefore the policy can be harmful e.g. worsening inflation

2. Also decision making by MPC receives no or minimal political intervention. This has been the case since May 1997, where the Labor government granted BOE independent. This is necessary as some politicians may influence the central bank to pursue policy that enables the economy to grow in short run, regardless of long run effect. It is part of effort to help candidates during elections

3. With the effect of multiplier, an initial increase in consumption & investment spending will lead to a multiple increase in AD. By then, real GDP will increase much more, thus achieving greater employment at the same time. However economists argue that how effective is the multiplier depends on mpc (marginal propensity to consume). The greater they are, the higher will be the multiplier

4. Somehow, just like fiscal policy, monetary stance does suffer from both recognition & effect lags. Recognition lags refer to time between the beginning of inflation or recession & the recognition that it is actually occurring. Meanwhile effect lags refers to time taken before the effects can be seen in economy. It is said that monetary policy may take up to 2 years or even more, for instance to change the consumption pattern of households. Some of them may take fixed-rate mortgages

5. Effectiveness of monetary policy to achieve greater economic growth depends on whether the UK economy is near full employment or not. If it is, real GDP will not increase by much, only price level will exacerbate

6. Major role of MPC is to achieve price stability & that is to ensure it falls within the targeted rate of CPI 2% +/- 1%. Thus the objective of achieving higher economic growth may be viewed as ‘secondary goal’

7. There is conflict of macroeconomic objectives. While slashing interest rates can help steer economic growth & reduce unemployment, it is done at the expense of higher inflation

8. Slashing interest rates may not be effective to increase consumption & investment spending, if the reduction is minimal say 25 basis points. However some may argue that it does affect those who take up huge loans. Also its effectiveness depends on other factors like consumer & business confidence, prices of house, government commitment on its fiscal spending etc

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