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Monetary Policy: the 2% inflation target
We have seen how both inflation and deflation can have negative impacts on households, businesses and on the economy generally. This takes us to monetary policy, which is a set of tools and policies controlled by a central bank. According to the UK’s central bank, the Bank of England, "Monetary policy is action that a country’s central bank or government can take to influence how much money is in the economy and how much it costs to borrow”.
The Bank of England uses two main monetary policy tools to keep to its 2% target: Bank Rate and quantitative easing. Bank Rate is the interest rate that the Bank of England charges banks to borrow money from it. Quantitative easing is the process of creating money electronically and using it to buy bonds from the government and businesses. Using these tools, the bank chooses between expansionary or tightening monetary policy. The bank often has to react to economic shocks such as the 2008 Global Financial Crisis or 2020 Covid-19 Pandemic with expansionary monetary policy.
The main objective of monetary policy is to keep inflation low and stable at the Bank’s target of 2%. Low and stable inflation is good for the UK’s economy and it is the Bank of England’s main monetary policy aim. The 2% inflation target is important because it helps to maintain confidence in the value of money, avoid excessive inflation or deflation, and support economic growth and employment. If inflation is too high or too low, or if it moves around a lot, it can have negative effects on the economy and people’s welfare. If inflation is above the 2% target, the bank may choose to increase the interest rate to reduce inflation, and vice versa.
Expansionary Monetary Policy: This is when the Bank of England decreases the 'bank rate' or increases the amount of money in the economy through a process called Quantitative Easing (QE). When the bank rate is lower, it means borrowing money becomes cheaper which can help encourage spending and boost the economy, but also contributes to inflation.
Tightening Monetary Policy: This is when the Bank of England increases the 'bank rate' or reduces the amount of money in the economy through a process called Quantitative Tightening (QT). When the bank rate is higher, it means borrowing money becomes more expensive which can help slow down inflation.
The Bank of England decides what action to take based on its analysis and projections of the economy and inflation. It has a Monetary Policy Committee (MPC) that meets eight times a year (roughly once every six weeks) to set monetary policy. The MPC has nine individual members who vote on whether to change interest rates or quantitative easing.
The MPC make their decision based on the 2% inflation target. If they think inflationary pressures are high, they tend to tighten monetary policy. If they think inflationary pressures are low, they tend to expand monetary policy.
The impact of expansionary and tightening monetary policy
Expansionary Monetary Policy | Tightening Monetary Policy | |
Households | Borrowing money for things like houses can become cheaper, but money saved in the bank earns less | Borrowing money for things like houses can become more expensive, but money saved in the bank can earn more |
Businesses | Borrowing money for expansion can become cheaper, making growth easier | Borrowing money for expansion can become more expensive, making growth harder |
Government | Borrowing money for public services can become cheaper, possibly leading to more spending | Borrowing money for public services can become more expensive, possibly leading to cuts |
Savers | Money saved in the bank can earn less | Money saved in the bank can earn more |
Importers/Exporters | A weaker pound can make imports more expensive and exports cheaper. A lower interest rate weakens the exchange rate, weakening the pound. | A stronger pound can make imports cheaper and exports more expensive. A higher interest rate leads to a higher exchange rate, making the country more attractive to foreign investment. |
Employees | Faster economic growth could mean more job opportunities and faster wage increases | Slower economic growth could mean fewer job opportunities and slower wage increases |
Retirees | Lower returns on savings can negatively impact retirees. | Higher returns on savings can benefit retirees. |
Investors | Lower interest rates can lead to lower returns on bonds but could stimulate the growth of the stock market if it offers better returns. | Higher interest rates can lead to higher returns on bonds but could slow down the growth of the stock market as it may offer weaker returns. |