Monetary Policy: Interest Rates

Determined by the Bank of England, monetary policy is one of the most crucial methods of meeting various macroeconomic objectives. However, where it helps meet certain objectives, it can hinder advancing others. In this article, we will explore the monetary policy that is more commonly used – the manipulation of interest rates.

An interest rate represents the cost of borrowing, in the form of interest owed, and the return on saving which is the interest received for keeping money in your account (we’ll look at why banks pay you to keep money in your account in a future article). The base interest rate is set by the Bank of England – more specifically, the MPC, or Monetary Policy Committee. This is a panel of 9 experts on the UK economy and macroeconomics, with a mix of Bank of England employees (including the Governor) and external members who are seasoned professionals in their respective fields. They meet 8 times a year, assessing how close they are to macroeconomic objectives and deciding if any action needs to be taken if they are not near their goals. This involves deciding the base interest rate.

The base interest rate is the rate at which the Bank of England lends to high street banks, which in turn influences the rate at which high street banks lend to consumers. Increasing the interest rate increases the cost of borrowing, and thus the cost of consumption. This causes a reduction in consumption, leading to a reduction in AD (Aggregate Demand) which can lower the price level from PL1 to PL2, as seen below. Therefore, raising the interest rate is a form of fighting inflation, when it exceeds the target of 2% +/- 1%. For example, this is why the Bank of England recently increased the base interest rate to 1% despite the current cost of living crisis (as of 16/05/2022).

On the other hand, lowering the interest rates makes it cheaper to spend, increasing consumption. The consequential increase in AD increases output from Y1 to Y2, as seen below. The Bank of England does this when the economy is in or at risk of recession, and so the decrease increases real GDP and tries to meet the macroeconomic objective of stable and steady economic growth. A prominent example is during the 2008 Financial Crisis (another topic to be covered in a future article) – the interest rate fell from roughly 5.8% in 2007 to just 0.5% in 2009 in a desperate attempt to revive the economy. This was a reduction of around 5.3% over the span of 2 years.

When considering the drawbacks of manipulating interest rates, it is much simpler to think about in terms of opportunity cost. By increasing the interest rate, you are fighting inflation but sacrificing economic growth – when lowering the rate, it is the opposite. This shows that there is a direct conflict of macroeconomic objectives, and therefore highlights the necessity of the MPC – without experts deciding, it could go very wrong (although it still goes wrong even with these experts).


One response to “Monetary Policy: Interest Rates”

  1. avatar

    Excellent synopsis


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