How Monetary Policy Works

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Submitted By john
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HOW MONETARY POLICY WORKS

We need to examine how the Bank uses monetary policy, not just to set interest rates but by intervening in the money market on a daily basis to ensure that the rate it has set becomes the equilibrium rate. This then has the longer-term effect on a range of variables, thus the Bank is able to meet its inflation target.

Source '' The Bank of England

The Bank sets a rate of interest at which it lends to banks, this affects the rates at which the banks, building societies and other financial institutions set for their own lenders and indeed savers. When the Bank alters the interest rate it is attempting to influence the level of spending in the economy. The Bank ensures there is a shortage of liquidity and then supplies funds through the repo and discount markets at the chosen rate, this then has a knock on effect throughout the economy. Sloman et al (2007).

We have examined how the MPC set “nominal interest rates”, true rates are set by the market, they are just another price: the price of spending today instead of next year, Harford (2006).

The following is likely to happen in the economy when the Bank reduces rates ''

Saving becomes less attractive to individuals and they are likely to spend more. Borrowing becomes cheaper; individual borrowers then have more disposable income, which they are likely to spend. Over the last decade rates have been at a historically low level, the availability of cheap money has led to increased consumer spending, as result borrowing on credit reached £1.2 TRILLION in the UK.

Firms with bank loans or other borrowings will have less interest to pay; they may well spend on other things. In addition firms invest more because any large investment becomes cheaper to finance. Both of these actions will increase the level of spending either in the UK, increasing domestic demand or by purchasing…...

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