Interest rates etc

The Monetary Policy Transmission Mechanism

It is worth remembering that when the Bank of England is making an interest rate decision, there will be lots of other events and policy decisions being made elsewhere in the economy, for example changes in fiscal policy by the government, or perhaps a change in world oil prices or the exchange rate. In macroeconomics the ceteris paribus assumption (all other factors held equal) rarely applies!

• There are several ways in which changes in interest rates influence aggregate demand, output and prices. These are collectively known as the transmission mechanism of monetary policy
• One of the channels that the Monetary Policy Committee in the UK can use to influence aggregate demand, and inflation, is via the lending and borrowing rates charged in the financial markets.
• When the Bank's own base interest rate goes up, then commercial banks and building societies will typically increase how much they charge on loans and the interest that they offer on savings.
• This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend — and so depresses aggregate demand
• Conversely, when the base rate falls, banks cut the market rates offered on loans and savings and the effect ought to be a stimulus to demand and output.

Read more

Macro economic objectives and conflicts - read this link!

Conflicts of objectives and interest rates

The effect of raising interest rates

Interest rates and the economy

Monetary....Fiscal....Supply-side...

Monetary policy - the effect of interest rates

The Monetary Policy Transmission Mechanism

It is worth remembering that when the Bank of England is making an interest rate decision, there will be lots of other events and policy decisions being made elsewhere in the economy, for example changes in fiscal policy by the government, or perhaps a change in world oil prices or the exchange rate. In macroeconomics the ceteris paribus assumption (all other factors held equal) rarely applies!

• There are several ways in which changes in interest rates influence aggregate demand, output and prices. These are collectively known as the transmission mechanism of monetary policy
• One of the channels that the Monetary Policy Committee in the UK can use to influence aggregate demand, and inflation, is via the lending and borrowing rates charged in the financial markets.
• When the Bank's own base interest rate goes up, then commercial banks and building societies will typically increase how much they charge on loans and the interest that they offer on savings.
• This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend — and so depresses aggregate demand
• Conversely, when the base rate falls, banks cut the market rates offered on loans and savings and the effect ought to be a stimulus to demand and output.

A key influence played by interest rate changes is the effect on confidence – in particular household's confidence about their own personal financial circumstances.

Read more

Monetary Policy

Monetary and Fiscal policy

Problems in recovering from a recession

To recover from a recession there needs to be either a rise in AD or a readjustment in prices and wages.

Classical economists argue that a recession will only be temporary because labour and product markets are flexible. However Keynesians argue that wage and price rigidity can keep the economy below full capacity for a long time.

For example to regain equilibrium it may be necessary to reduce prices and therefore reduce nominal wages by an equivalent amount. However this may be difficult because trades unions will resist cuts in nominal wages, also firms would be willing to cut wages because it may lead to lower productivity amongst workers.

1. Low Consumer confidence.

 In a recession there will be rising unemployment and therefore a fall in consumer confidence. This will cause a rise in the savings ratio. In other words, people will spend less of their disposable income and save more leading to a bigger fall in AD. If confidence remains very low for a long time then it will be difficult for the govt to increase AD. For example, if the govt cut income taxes this would increase disposable income, but if confidence was low people would not be willing to spend any extra and the economy would remain in a recession.

2. Ineffectiveness of Monetary Policy.

 In a recession the Bank of England could cut interest rates to stimulate demand. Lower interest rates reduce the cost of borrowing and therefore people should be more willing to spend and invest. However, Monetary policy could be ineffective. Firstly, firms may be reluctant to invest, even though it is cheap to borrow because they cannot see any increase in demand. If a country is a member of the EURO it may make it more difficult to increase AD in a recession. This is because interest rates will be set by the ECB and the UK would lose control over interest rates. Interest rates may be too high if the UK is in a recession and other countries in the Euro zone are growing.

3. Effectiveness of Fiscal Policy.

Keynesians argue that expansionary fiscal policy can be used to increase AD and get the economy out of a recession. However, there may be many problems of using fiscal policy to increase AD.

• Firstly there will be time lags. It takes time for the govt to change its spending plans and once implemented it will take time for this spending plan to actually increase AD
• Also increasing AD may cause crowding out. This means that if the govt increases its spending then it will lead to a corresponding fall in private sector spending. This is because the govt borrows off the private sector to finance its spending. However Keynesians reject this argument saying that the govt will only be using previously unemployed resources therefore there will be no crowding out.

4. Deflation.

 If there is deflation this makes it difficult to increase demand. This is because people will not spend if they feel that prices will be cheaper in the future. Also, Monetary policy will become ineffective because interest rates cannot fall below 0% therefore with deflation real interest rates may remain high. E.g. Japan has experienced deflation during the 1990s and this made it very difficult to increase AD and economic growth.

5. Hysteresis.

This states that what has happened in the past will affect the future. For example if unemployment is high then it is likely to continue being high. If people are  unemployed for a long time they become de-motivated and less employable because they are now less skilled (less on the job training). Also if productive capacity is not used for a long time then it firms will shut factories down completely, causing a fall in AS. Therefore in a prolonged recession there will be not just a fall in AD but also a fall in AS causing a permanent fall in the potential output of an economy. This occurred during the Great depression of the 1930s.

6. Supply side shocks.

If there was a fall in AS as well as AD this would make the recession more severe. For example if there was a rapid rise in the oil price like in the 1970s then AS would shift to the left causing lower growth and higher inflation.

Read more

Monetary and Fiscal Policy

Reducing unemployment

There are two main strategies for reducing unemployment –

• Demand side policies to reduce demand-deficient unemployment (unemployment caused by recession)
• Supply side policies to reduce structural unemployment / (the natural rate of unemployment)

Quick list of policies to reduce unemployment:

1. Monetary policy – cutting interest rates to boost AD
2. Fiscal policy – cutting taxes to boost AD
3. Education and training to help reduce stuctural unemployment
4. Geographical subsidies to help firms invest in depressed areas
5. Lower minimum wage to reduce real wage unemployment
6. More flexible labour markets, to make it easier to hire and fire workers.

 Read more and click the links

Evaluation Monetary Policy

1. critically examine the effectiveness of monetary policy.

2. what factors do you think limit the effectiveness of monetary policy.

Previously, I have written an essay – what determines the effectiveness of monetary policy

In brief, the aim of monetary policy is to target low inflation (CPI = 2% +/-1). But, also to maintain a steady rate of economic growth. In recent months it has been difficult for the Bank of England to achieve both these objectives. This is because we have had cost push inflation (rising oil, food prices). The cost push inflation causes rising prices and falling economic growth. Therefore, even though inflation has increased to over 4%, the Bank don’t want to increase interest rates because the economy is already slowing down. Therefore, they have left interest rates the same and have been unable to keep inflation on target.

However, in period 1997-2007, monetary policy effectively kept economic growth and inflation stable. This was because cost push inflation was low and the independent Bank of England was successful in preventing growth exceeding the long run trend rate.

However, in the great moderation, despite low inflation, there were imbalances in the economy – such as rising house prices and boom in credit. This shows limit of monetary policy in preventing credit bubble.

2007-2011

Between 2007 and 2011, monetary policy became much more difficult. This was because of:

Cost push inflation and recession. In 2008 and 2011, the UK experienced a rise in CPI inflation to over 5%. (see: cost push inflation) Yet, at the same time, economic growth was very low or negative. This present the Bank of England with a difficulty. On the one hand, inflation is above their target so they should consider raising interest rates. However, with a depressed economy, the economy needs the opposite.

Liquidity Trap In 2008, the economy was in a liquidity trap. Cutting interest rates to zero, failed to boost spending and economic growth. Therefore, the Bank of England were forced to pursue quantitative easing.

 Read more

Advantages of MPC in setting interest rates

1. They are independent. They are not subject to political pressures. E.g. they are not tempted to keep interest rates low before an election. This used to be a problem for UK economy, with many experiences of boom and bust economic cycles.

2. Monetary Policy is pre-emptive. They try to prevent inflation before it occurs. They predict future inflation trends. If inflation looks to be increasing above the govts target then they can increase interest rates to reduce consumer spending and keep inflation on track.

3. MPC have reduced inflation expectations. People have confidence that inflation will remain low. Therefore wage demands are lower and it becomes easier to keep inflation low.

4. By targeting inflation directly they get the best overall picture of the economy rather than focusing on small aspects like the money supply.

5. Since 1997 UK inflation has remained close to the government’s target of 2%. This is much lower than UK inflation in the 1980s which reached 10%

6. Interests rates have a powerful effect in influencing UK consumer spending. This is because many people have mortgages or other types of loans.


Limitations of the MPC’s Effectiveness

1. Inflation is low but this is partly due to global pressures keeping inflation low. E.g. globalisation, low prices of raw materials and better technology. If these factors were to increase it would be much more difficult for the MPC to keep inflation low.

2. Interest rates have a time lag. It is estimated it takes 18 months for interest rates to have an effect. Therefore it becomes difficult to control inflation solely through interest rates.

3. Some sections of the economy do not respond to higher interest rates. For example the recent rises in interest rates have not stopped house prices rising. Many older people have a small mortgage therefore changes in interest rates have little effect. However interest rates have a disproportionate effect on people who have just joined the housing market ladder.

4. It depends upon other components of AD. E.g. if consumer confidence is high then raising interest rates may have little effect on reducing consumer spending.

MPC have done a good job so far. However the real test may come when there is a rise in structural inflation or global instability.

Read more

Quantitative Easing

People's QE and Corbyn’s QE

Politicians can be adept at co-opting attractive sounding terms to their own cause, even when they distort their meaning while doing so. Osborne announced what was in reality a partial but large increase in the minimum wage, but he called it a ‘living wage’. This was especially devious, as calculations of the actual living wage take into account the tax credits that Osborne was at the same time cutting.

Is Labour leadership contender Jeremy Corbyn’s ‘Peoples QE’ an example of the same thing? It is certainly true that the way that some macroeconomists, including myself, have used the term is different from Corbyn’s idea. For us Peoples QE is just another term for helicopter money. Helicopter money was a term first used by that well known radical Milton Friedman. It involves the central bank creating money, and distributing it directly to the people by some means. It is a sure fire way [1] for the central bank to boost demand: what economists sometimes call a money financed fiscal stimulus.

The idea has been recently revived, most prominently in the UK by Adair Turner, because of the failure of conventional monetary policy (changing interest rates) to bring a quick end to the Great Recession, which in turn is because governments were undertaking fiscal austerity (a bond financed fiscal contraction) rather than fiscal stimulus. In contrast central banks in Japan, the US and UK, and now the Eurozone, have been creating money to buy financial assets (mainly government debt), which is called Quantitative Easing (QE). Hence the term People’s QE for helicopter money: instead of the central bank creating money to buy assets, it creates money and gives it to the people.

The genesis of Corbyn’s QE seems rather different. Corbyn adviser Richard Murphy had previously suggested what he called a Green Infrastructure QE, which is that a “new [QE] programme should buy the new debt that will be issued in the form of bonds by the Green Investment Bank to fund sustainable energy, local authorities to pay for new houses, NHS trusts to build new hospitals and education authorities to build schools.” This in turn is related to two ideas: first a near universal view among macroeconomists that public sector investment in infrastructure should be rising not falling when interest rates are low and labour is cheap, and second that a National Investment Bank (NIB) might be useful in helping to encourage private sector investment. (See, for example, the recommendations of the LSE growth commission.)

The main difference between helicopter money and Corbyn’s QE therefore seems to be where the money created by the central bank goes: to individuals in the form of a cheque from the central bank, or to financing investment projects. I think that is wrong, and to see why we need to ask an obvious question: what is this policy innovation designed to achieve. I think it is here that confusion has arisen.

As I noted above, the idea behind helicopter money is to provide a tool for the central bank to use when interest rate changes are no longer possible or effective. With an independent central bank, that means that they, not the government, get to decide when helicopter money happens. In contrast, if your goal is to increase either public or private investment (or both) for a prolonged period, then its timing and amount should be something the government decides. While QE is hopefully going to be something that is unusual and rare, the goal of an investment bank is generally thought to be more long term, and not something that only happens in severe recessions.

For that reason, Corbyn’s QE looks like one of those ideas that is superficially attractive because it seems to kill two birds with one stone, but on reflection turns out to be a bad idea. If we want to keep an independent central bank we do not want the government putting the bank under pressure to do QE because the government wants more investment, and if that does not happen we do not want the central bank deciding whether extra investment happens. Indeed some of those who dislike the idea of helicopter money have already been using Corbyn’s QE to say ‘I told you helicopter money was a slippery slope that would lead to the end of central bank independence’.

However I think it is unfair and unproductive to leave it there. Suppose that a NIB is created, not on the back of QE but using more conventional forms of finance. (If the government wants to encourage it, just directly subsidise that finance with conventional borrowing. Don’t be put off doing so by deficit fetishism.) Suppose we also like the concept of helicopter money - not for now, but for the next time interest rates hit their lower bound and the central bank wants more stimulus. In those circumstances, it might well make sense for helicopter money to be used not only to send cheques to individuals, but also to bring forward investment financed by the NIB, or public sector investment financed directly by the state. If those investment projects could get off the ground quickly, and crucially would not have happened for some time otherwise, then what I have elsewhere described as ‘democratic helicopter money’ would make sense. [2] This is because investment that also boosts the supply side is likely to be a far more effective form of stimulus than cheques posted to individuals.

So one day, this form of Corbyn’s QE could happen. But we need to get the idea of helicopter money, and the need for public investment and a National Investment Bank, accepted in their own right first. Putting the two ideas together right now is misconceived, and is in danger of discrediting two potentially good ideas.

Original article with follow-up questions