What is monetary policy?

The Bank of England is England’s central bank. A central bank can use monetary policy to affect the amount of money in the economy and the cost of borrowing. The bank uses two primary instruments to do this, the interest rate and quantitative easing. The interest rate is what the bank charges to borrow money and it is known as the “Bank Rate.” 

Secondly, through Quantitative Easing, the bank can purchase bonds to cut interest rates on savings and loans.

What is monetary policy used for?

The bank uses monetary policy to keep inflation at 2%. Their primary monetary policy objective is low and stable inflation since it is beneficial to the UK economy. 

The bank also supports the government’s additional economic objectives for low unemployment and growth. These objectives must be balanced with maintaining low inflation.

Interest rates

The interest rate determines the cost of borrowing money but it also determines the return you get on saving money. The Central Bank, the Bank of England, sets the ‘base rate’. This is the rate at which the Central Bank lends money to the commercial banks. The ‘base rate’ is currently 1.75%. If the Central Bank raises the base rate, Commercial banks will too. This is because borrowing from the Central Bank is more expensive.

Lowering interest rates is what is known as expansionary policy (to encourage activity and economic growth). This will:

• Reduce the incentive to save – lowering interest rates will leave savers with a smaller return on their savings.
• Make it cheaper to borrow money – lowering interest rates will mean that the repayments on loans are smaller. This will encourage consumers and businesses to spend and invest.
• Low mortgage payments – if homeowners are on a mortgage where the interest rate is determined by the ‘base rate’, their repayments will be smaller. This means that they will have more disposable income to spend.
• Rising asset prices – lowering interest rates will increase demand for houses. This is because the cost of borrowing money for a mortgage will be smaller. As the demand for houses rises, the prices will also rise and there will be an increase in wealth. When there is a positive wealth effect, confidence surrounding the economy is higher and this will encourage consumer spending. 

Quantitative Easing

Quantitative Easing is very similar to cutting the Bank Rate – it is an expansionary policy. The aim of QE is to increase economic activity. It is when the Bank of England digitally creates funds. This will increase bank reserves and they do not need to be printed in the form of cash. The bank will then purchase government/corporate bonds or other securities like pension funds. 

This will achieve:

• Increased liquidity – banks can sell these bonds for cash. This means that they will see an increase in their liquidity (cash reserves). Hypothetically, the banks will be able to lend to more customers. This will encourage customers to spend and businesses to invest.
• Lower interest rates – when the bank buys these assets, it will reduce their interest rate. This will then translate into lower interest rates on loans for households and businesses.
• Rising asset prices – banks can sell these bonds for cash, but they can also use this to invest in other assets which can give them a greater return. This will push up the value of shares and there will be a positive wealth effect.

How much Quantitative Easing has the bank done in the UK?

In response to the Financial Crisis, the bank started to purchase bonds. They have purchased £895 billion worth of bonds through QE between 2009 and 2021. The majority of that sum was spent on government bonds (£875 billion). A smaller amount (£20 billion) was used to purchase UK corporate bonds.

Here is a chart that shows the gradual increase in QE over the years.

How the bank decides to use monetary policy

The Monetary Policy Committee decides what policy action to take. They set and announce policy eight times a year. They hold multiple meetings to assess the economy before deciding what action to take.

It can take a while for monetary policy to have an effect on the economy, so the Committee must take into account what inflation and growth will look like in the coming years. 

Footnotes:

https://www.bankofengland.co.uk/monetary-policy/quantitative-easing
https://www.bankofengland.co.uk/monetary-policy