UK Monetary Policy

The Bank of England uses monetary policy to meet national inflation targets.

Monetary policy is the method by which a nation, through its central bank, tries to control and regulate its supply of money. In the United Kingdom, the Bank of England uses monetary policy to achieve monetary stability, meaning low inflation. The bank's policy makers, guided by government inflation goals, try to protect the value of money, laying a foundation for long-term economic stability.

Identification

The Bank of England, one of the world's oldest central banks, is in charge of the United Kingdom's monetary policy. It is the U.K.'s equivalent of the U.S. central bank, the Federal Reserve.

Function

Monetary policy strives to foster stable economic growth, primarily through control of inflation. High inflation reduces the value of money by limiting its purchasing power. This affects the Gross Domestic Product--of which consumer spending is a major component--and national employment. The 1998 Bank of England Act codified the bank's goals, setting an annual inflation target of 2 percent. Through its policy decisions, the Bank of England supports the government's inflation target.

Types

The Bank of England uses two types of monetary policy tools: the interest rate at which it lends to commercial banks and other financial institutions, and direct injections of money (known as quantitative easing) into the British economy. The interest rate, known as the Bank Rate, affects market interest rates charged by banks and other institutions. Quantitative easing occurs when the Bank of England injects money directly into the economy by purchasing British government bonds (known as gilts) or high-quality corporate bonds.

Time Frame

The Bank of England's Monetary Policy Committee meets monthly to set the Bank Rate. During its meetings, the committee assesses the state of the economy and the direction of inflation. Committee members base their Bank Rate decision on where they believe the British economy is headed. Once the committee changes the Bank Rate, there is a time lag before the new rate affects the economy as a whole. It may take more than a year before a change in the Bank Rate influences market interest rates, consumer prices, and the saving and spending decisions of the British public.

Effects

The Monetary Policy Committee's Bank Rate decision affects interest rates in the British banking system. An increase in the Bank Rate raises market interest rates, while a decrease lowers them. Higher interest rates reduce the nation's money supply by increasing interest received on savings and raising the costs of borrowing. This reduces consumer spending, exerting downward pressure on prices. Lower interest rates, meanwhile, stimulate consumer spending. When inflation appears to be below the government's annual target, interest rates often fall.

Considerations

The global financial crisis of 2008 signaled a need to inject additional money during times of rapid economic decline. A reduction in the Bank Rate lowers interest rates and raises the money supply, but requires time to take effect. In March 2009, the Bank of England's Monetary Policy Committee announced it would use quantitative easing as a means of pumping additional money into the economy more directly. This, in part, was the Bank of England's response to the problems created by the worldwide credit crunch.

References

• Bank of England: how monetary policy works

Resources

• Bank of England: Monetary Policy