The case study is prepared based on the dynamics of inflation, interest rate and monetary policy committee on United Kingdom. Monetary Policy Committee of Bank of England is responsible for designing monetary policy in the economy. The committee is ready to adjust the interest rate in line with fluctuation in the price level. In the phase of rising inflation, the committee raises interest rate while during a declining phase of inflation MPC sets the interest rate to a low level. Given a relatively low inflation rate, MPC currently does not have any pressure for raising inflation rate. The case study discusses the concept of real interest rate along with assessing the role of MPC in controlling inflation. Additionally, the demand side policy responses of GFC and likely impact of a rise in value pound in aggregate demand is analyzed to draw a firm conclusion regarding current state of economy.
Interest rate represents the charge on borrowed fund. The nominal interest rate is the interest rate that does not consider inflation rate into account. The inflation however affects the effective rate of interest and hence, alters the burden of interest. During inflation, the value of money reduces. Hence, borrower paying nominal interest rate gain while lender loses because of a small effective return. Reverse is the case during a downward movement of price. Therefore, inflation should be taken into consideration for evaluating real return of funds. The real interest rate is the inflation adjusted return (Goodwin et al. 2015). The interconnection between nominal and real interest rate and that of inflation rate is stated by the Fisher Equation given as Real interest rate is a tool to understand the nature of monetary policy. A low real interest rate indicates that a stimulatory monetary policy while a high interest rate implies prevalence of a tight monetary policy.
The monetary policy committee of UK has the responsibility to meet an inflation target. The committee aims to maintain a targeted inflation rate of 2%. The monetary policy committee design monetary policy to stabilize price and provides confidence to the currency. The committee has faced some difficulty in achieving its inflation target in recent years. After the hit of global recession UK CPI inflation is average at 3%. In December 2013, the inflation backed to the level of 2% (bankofengland.co.uk 2018).
The figure above shows the movement of price level in UK since 2011. After the global financial crisis, because of unstable economic condition inflation has reached to a level of 4.48%, above than the inflation targeting. Since 2011, inflation rate started to decline and become as low as 0.05% in 2015. In recent years, inflation has accounted a slightly increasing trend mainly due to depreciation of pound and resulted increase in import price.
The main instrument used to control inflation is the interest rate. The figure above shows the trend in UK base interest rate. For a prolonged period of 2009 to 2016, the inflation rate has remained unchanged at 0.5 percent. In response to a very low inflation rate of 0.05%, the committee reduced the bank rate to the lowest level of 0.25 percent to provide necessary stimulus to the economy (Hanson and Stein 2015). The price level then recovered and reached to the level of 2.69%. The interest has again revised to set at its earlier stable rate of 0.50%.
The price level in UK often experiences temporary shocks from domestic and international market. For example, a fall in sterling, global energy price shock and an increases in VAT increases contributed to an increase in the inflation rate in UK over four years. The impact of such temporary global shocks are generally accommodated by the monetary policy framework. The second round effect of such shock in developing inflation expectation or wage settlement is not relevant in context of UK economy (assets.publishing.service.gov.uk 2013). The flexibility of MPC to allows price level to deviate from target level flowing temporary shocks enhances credibility of the committee to maintain medium term price stability anchoring inflation expectation. The stable inflation and a low base rate currently indicates MPC has no pressure to increases the interest rate. The committee however is ready to make an upward revision of the interest rate if price level accounts an increase.
The phenomenon of a continuous decline in price level is termed as deflation. Deflation becomes an economic concern when the movement in price level is associated with price of long term asset and is built into the expectation of policymakers. In recent years, UK has experienced a decline in value of pound against most of its trading partners ((Cloyne and Hürtgen 2016). The depreciation of currency increases price of the imported goods. The main indicator of inflation, consumer price index in UK is rising. The declining price of fuel helps to offset price increase commodities of basic need like food, clothes and other necessary household good.
The inflation in UK has remained at a low level. In the last 60 years, the average inflation rate in UK stays around 5.5%. The inflation targeting has become one of the top priority of government. The continuous effort of government has kept the interest rate to a relatively low level 2.6% (theconversation.com 2018).
Objective of Bank of England is to maintain the inflation at around 2%. The main drivers of soaring inflation in recent years is the depreciation of sterling. Price though estimated to be higher but will be stable. During deflation prices in the economy fall imposing a restriction to long term growth. The deflation potential for UK economy is evident. The Brexit referendum is expected to have a long term adverse effect on household income and disposable income. The Brexit thus hitting consumer spending has a high chance to drag the price level to an unexpected low level creating concern for Bank of England and Monetary Policy Committee.
During economic shocks a set of demand and supply side policies are undertaken to combat the recessionary effect. In response to global financial crisis UK government took a several policies to provide necessary stimulus to the economy. In times of the crisis, the UK economy required effective fiscal action to boost aggregate demand. Tax and government expenditure are the two fiscal policy tools. During 2008, the government announces a tax cut of £145 on basic rate for the taxpayers. The tax exemption was applicable for taxpayers earning an income of £34,800 per annum. On the sales tax a temporary rebate of 2.5% was given for value added tax (Wanna, Lindquist and De Vries 2015). Government also focused on increasing tax investment spending. A £3 billion worth of investment was announced from 2010 onward. Government had launched different schemes such as Small Enterprise Guarantee Scheme. The estimated government expenditure for these various measures roughly equal £20 billion. An additional £5 billion spending as made for conducting training program in order to help young unemployed people.
The economic growth and price level in the economy is determined from the balance between aggregate demand and aggregate supply (Uribe and Schmitt-Grohé 2017). AD and AS curve respectively represents the aggregate demand and aggregate supply. Now, expansionary fiscal policy to boost demand shifts the aggregate demand curve outward. The aggregate demand curve shifts rightward from AD to AD1. The new equilibrium is at E2. E2 is associated with a higher output Y2 and a higher level of price to P2.
The limited ability of UK government to take discretionary fiscal policy action resulted in significant debt burden for the government. The government debt has estimated to be £175 billion accounting 12.4% of GDP. The net borrowing of government during 2014-14 was £102.3 billion (Bhattarai, Haughton and Tuerck 2015).
Aggregate demand in an economy the sum demand generated from different sectors of the economy. It is represented as the sum of expenditure made in a given year. The four principle component of aggregate demand are consumption expenditure, investment expenditure, government expenditure and net export. Net export represents the balance of trade and obtained as earnings from export less spending on import (Gandolfo 2016). Factors causing change in any of these causes a change in the aggregate demand. The volume of trade and hence, net export depends on the relative value of the currency. An increases in the value if currency reduces the price of import while making export more expensive. Opposite is the case for a decline the value of currency.
Aggregate demand curve depicts the relation between national output and corresponding level of price, any change in aggregate demand causes national output and price level of change. The increase in the value of pound implies home currency of UK has become expensive relative to foreign currencies. This benefits UK citizen to enjoy a cheaper price of the import. The currency appreciation however hurts the export sector by reducing increasing relative price of UK export in the world market. Increase in import along with a decline in export reduces net export of UK. A decline in net export in turn causes a decline in aggregate demand shifting the aggregate demand curve to the left (Bernanke, Antonovics and Frank 2015). The likely impact of this is shown in the following figure.
The MPC thus should be concerned with potential implication of Brexit. A much bigger concern for persistent fall in price is creation of spare capacity in time of deflation. This causes a shift in expectation imposing a threat to long run growth prospects.
As discussed above an appreciation of pound reduces the aggregate demand. This shifts the aggregate demand curve inward from AD1 to AD2. As a result of decline in aggregate demand, real GDP declines from Y1 to Y2 while price level fall from P1 to P2.
Conclusion and Recommendation
The monetary policy committee in UK designs monetary policy depending on state of the economy. Current inflation target of the committee is to stabilize the price level at 2%. The committee has maintained a low interest rate of 0.50%. Price level in an economy is vulnerable to temporary shocks. The flexibility of MPC helps to maintain a stable state of price in the long run bypassing the temporary shocks. At present inflation is fairly stable. Therefore, the committee does not need to increases interest rate now. The low inflation rate has a potential for bringing deflation which should be taken care of. During GFC, in addition to monetary policy stimulus fiscal instruments like tax cut, increases in government expenditure and other are used to stabilize the economy.
The current interest rate at set a low level of 0.50%. However, too low interest rate has a component that can itself crates an inflationary pressure. When the economy operates almost at the level of full employment then low interest rate by MPC over stimulate the aggregate demand beyond its capacity to react in the short run. The effect on low rates fall on price level instead of stimulating employment and output. The Bank of England and MPC should also be aware of any deflationary pressure that can restrict future economic growth.
References
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Cloyne, J. and Hürtgen, P., 2016. The macroeconomic effects of monetary policy: A new measure for the United Kingdom. American Economic Journal: Macroeconomics, 8(4), pp.75-102.
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Hanson, S.G. and Stein, J.C., 2015. Monetary policy and long-term real rates. Journal of Financial Economics, 115(3), pp.429-448.
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Ons.gov.uk. (2016). RPI All Items: Percentage change over 12 months: Jan 1987=100 – Office for National Statistics. [online] Available at: https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/czbh/mm23 [Accessed 25 Apr. 2018].
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The Conversation. (2018). Should the UK be worried about inflation? No – looming deflation is the real concern. [online] Available at: https://theconversation.com/should-the-uk-be-worried-about-inflation-no-looming-deflation-is-the-real-concern-82619 [Accessed 25 Apr. 2018].
Uribe, M. and Schmitt-Grohé, S., 2017. Open economy macroeconomics. Princeton University Press.
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