Monetary Policy, Inflation, and the Business Cycle - Essay Example

MACRO- AND MICROECONOMICS By Macro and Microeconomics Monetary policy can be defined as the process through which a country’s monetary authority influences how money is supplied in that particular state. These authorities target interest rates every so often with the intention of facilitating economic growth coupled with economic stability. The sanctioned objectives of such policies are normally inclusive of relative price stability as well as low levels of unemployment (Weale, 2013). Monetary policies can either be contractionary or expansionary. The former on the one hand, increases the aggregate money supply in a much slower manner or even reduces its size. The latter on the other hand, augments the overall money supply in the economy more precipitously. Expansionary policies are conventionally utilized in the attempt of combating unemployment in an economic downturn. This is achieved by depressing the rates of interest with the intention of allowing easy credit to entice business expansion. Contractionary policies are expected to decelerate inflation so as to prevent the consequential distortions combined with the relapse of the values of assets (Weale, 2013). The United Kingdom public might expect a change in monetary policies because of the falling unemployment and economic recovery that the country is experiencing. The change anticipated to happen is the overhauling or revamping of the interest rate policy of the Bank of England. The interest rates are to be determined by unemployment, among other indicators. The introduction of the forward guidance policy kept the bank from increasing interest rates to beyond 0.5 per cent. The bank governor, Mark Carney, however, asserted that the policy needed revising because of the outstanding strong growth in employment. This adjustment involves rising rates of interest. This is to be done following the observation of such indicators as spare capacity within the economy, wages as well as productivity. The bank is to provide predictions on these range of indicators based on expectations of the market of 1.5 per cent increase by the year 2017. The Bank of England outlined its stratagems for alterations in rates of interest in the future. This could probably mean more suffering for the saving population but there would continue to be inexpensive mortgage rates. The Bank would only consider increasing the current low interest rate levels if either inflation or unemployment or both was no longer manageable. The stratagem or change in monetary policy known as the forward guidance would affect the main indicators in macroeconomics such as income, price level as well as interest rates. The new Keynesian Model helps explain the impact of the forward guidance policy on various macroeconomic issues. The beauty of this framework is that it provides a summary of the progression of the economy as an end product of the equilibrium between supply and demand (Palley, 1996). The latter is epitomized by the supposition that growth in spending is highly dependent on interest rates. When rates of interest are low, individuals tend to opt for a path along which spending has gradual growth. However, when the rates are high, future goods appear to be cheap in comparison to present goods. For this reason, people transfer expenditure in the future and hence the growth in spending is likely to grow faster between now and in the future (Carlstrom et al., 2012). Supply is epitomized in the form of the celebrated Phillips curve that links inflation, expected future inflation as well as demand in relation to supply in the commodity market. The MPC is said to set rates of interest in relation to the rate of inflation combined with output deviation from its long run path. With the input of this model in the simulation of the impact of forward guidance, one finds that the policy has a grand effect on inflation along with productivity (Lucas, n.d.). One way of scrutinizing the impact of the policy change in rates of interest or other related variables is by observing their movements in the instantaneous end result of the announcement of the policy. If this policy directly stimulates production, if the new Keynesian model is to be assumed, then it should also bring about improved levels of anticipated future inflation. In the context of the country in question, that is, the United Kingdom, with levels of inflation above the target for a half a decade, the Monetary Policy Committee was careful in the implementation of this policy so that it did not incur stakes when it came to the issue of inflation expectations (Monetary Policy Committee, 2013). Did the policy affect in any way the inflation anticipations that corporations formed? This question is best answered by taking a look at the CBI. Records show that business inflation expectations went up in the third quarter of the current year immediately after the policy was announced. There was the bated breath of an upsurge in company prices as well as industry prices. An attempt to assess the effects of the policy of forward guidance brought about quite a number of various fragments of evidence that point in directions that are as like as chalk and cheese. Analyses based on various hypotheses suggest that the impact has to be formidable, so long as the guiding principle results in distinctly lower anticipations of the foreseeable path of rates of interest. Nonetheless, the enormity of the impact is susceptible to the scrupulous postulations fashioned about how the economy functions. But then again, were the policy to merely clarify what the implementers of policies were expected to have done, then the effect would not be outsized. All in all, because the policy is state dependent as opposed to being time dependent, the MPC has the ability to respond to its authentic bearing (Del Negro et al., 2013). Monetary policies are intended to manage the price of borrowing, that is, rates of interest. They are also designed to control the habit of consumers in combination with business entities, who are the spenders in the economy. Like all other central banks, the Bank of England intervenes in the market either directly or indirectly. One of these ways is through the setting of base rates and the other is by the injection of removal of cash from the economy. The policy of injecting or removing cash works under the law of supply coupled with demand. This simply means that when a particular commodity is available in plenty, then it costs much less. The inverse is also true. The establishment of base rates verifies what short term interest rates should be. Controlling the money supply in turn works to establish long term rates of interest. The forward guidance policy is an example of how the central bank intervenes indirectly to manoeuvre the market (Jossa & Musella, 1998). The Bank of England increased money supply in the United Kingdom through the purchase of government bonds, acquiring them from certain investors. By so doing, these investors are able to increase their cash balances hence money is injected into the economy. This is what is referred to as QE or Quantitative Easing. Reports disclose that the bank has secured three hundred and seventy five billion pounds of United Kingdom government bonds. This is in comparison to the United States’ continuing QE rate of eighty five billion US dollars every month (Campbell et al., 2012). The main reason as to why central bankers make use of QE is in an effort to bar the monetary end product of a monumental financial cataclysm. The 1929 crash of Wall Street is an infamous example. It was a time when a banking catastrophe brought about a profound depression that lacerated its Gross domestic Product (GDP) resulting in mass redundancy. The tight monetary policy implemented afterwards only worsened the situation. Interest rates have great influence in the way financial decisions are made in the economy. People have a tendency to borrow money for the purchase of capital paraphernalia such as cars and houses when the price of borrowing is low. Nonetheless, current rates of interest are not the only influence on decisions. It is also of great magnitude to ponder about the potential path interest rates are likely to take and whether or not it will be possible to service long term debt. Hypothetical consumers will also be very observant of the economic state; spending either stagnates or falls when there is an individual concern about job loss or escalation of rates. Forward guidance is intended to encourage consumers as well as corporations to spend and also borrow with the assurance that the rates will not upsurge in the predictable future. The deployment of this policy is on the basis of two reasons. First of all, with bank rates being at 0.5 per cent, there is a possibility of further drops being frivolous. The second reason is that economists seem to fail to agree on the issue of the implementation of QE. The monetary policy has hard certain effects on the labour market. To begin with, there has been negative growth in productivity. Given the recent sequel of events, it is to be anticipated that productivity growth will fall to its pre-crisis norm rate. Another effect is the colossal inefficiency of the labour market. One reason for this occurrence is that a sizeable share of the decline in redundancy was caused by a decline in the population of the long-term jobless individuals. This basically means that lower unemployment levels go hand in hand with stable inflation. Forward guidance simply means making promises about coming times, especially concerning potential interest rates. Akin to all other central banks, the Bank of England has direct control over short term rates of interest which it borrows from or lends to the high street financial institutions. This is the rate of interest determined by the banks monthly meetings of the MPC (Monetary Policy Committee). Upon the announcement of the policy, there was no instant up shot on expected interest rates that are yet to come. This suggests that after the declaration, there were no significant changes in the expectations. A possible explanation of this is that people were already looking forward to the publication of the policy. Even so, the pointers of improbability going about imminent near-term rates collapsed as an instant consequence of the announcement. Furthermore, this falling off has refused to go away (Levin, 2009). As a final point, the past couple of months have seen the bedding down of this central bank guideline, triggering off substantial alterations in the expectations of the population of the prospects of the growth of the British economy. There have been up surging anticipations of rates of interest still to come. Markets have understood that policies can back the economy in a significant way despite bank rates being at levels higher than what they presently are. Informal analyses of traders in the market propose that a couple of years in the future, expected rates would be about twenty five per cent lower than what they’d have been in the absence of the forward guidance policy. Holding this kind of perceptions all through the economy would make it possible for output to have a fifty to seventy five per cent increase. The effect on inflation would be slightly over twenty five per cent. Conversely, if households have not clearly comprehended this policy, initial effects could be truncated. This could be the reason as to why no proof of the effects of the policy on business expectations of increase in price levels can be found. References Campbell, J. R., Evans, C .L. Fisher, J.D. & Justiniano, (2012). A. Macroeconomic Effects of Federal Reserve: Forward Guidance. Brookings Papers on Economic Activity. 44, 1-80. Carlstrom, C, Fuerst, T & Paustian, M. (2012.) Inflation And Output Multipliers In New Keynesian Models with a Transient Interest Rate Peg. Bank of England Working Paper 459. Del Negro, M., Giannoni, M. & Patterson, C. (May 2013). The Forward Guidance Puzzle. Staff Report No 574. Gali, J. (N.D.) Monetary Policy, Inflation And The Business Cycle: An Introduction To The New Keynesian Framework. Princeton University Press. Top of Form Jossa, B., & Musella, M. (1998). Inflation, Unemployment, And Money: Interpretations Of the Phillips curve. Cheltenham, UK, E. Elgar. Bottom of Form Top of Form Levin, A. T. (2009). Limitations On The Effectiveness Of Forward Guidance At The Zero Lower bound. London, Centre for Economic Policy Research. Bottom of Form Lucas, R.E. (N.D.) Supply-Side Economics: An Analytical Review. Oxford Economic Papers. Vol. 42. Pp. 293-316. Monetary Policy Committee. (2013a). Monetary Policy Trade-Offs And Forward Guidance. Bank of England. Top of Form Palley, T. I. (1996). Post Keynesian Economics: Debt, Distribution, And The Macro Economy. Hound mills, Basingstoke, Hampshire, and Macmillan Press. Bottom of Form Weale, M.R. (2013) Monetary Policy And Forward Guidance. Speech Delivered At Quintin Kynaston Academy. 15th November. Read More