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How Does Monetary Policy Work?

Key terms:

Inflation - A general increase in prices in an economy and consequent fall in the purchasing value of money. 

Monetary policy - a set of tools used by a nation's central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements. 

Exchange rate - the value of one currency for the purpose of conversion to another.

GDP -  the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period.


 

In 2017 the United Kingdom experienced high inflation due to various factors, such as the decrease of the value of the pound, withdrawal from the European Union and increased economic growth.

Contractionary monetary policy (increasing interest rates by the central bank) was used in order to deal with high inflation. So, in this article the advantages and drawbacks will be discussed in order to understand whether implementation of monetary policy was effective for solving such economic issues as high inflation in this particular example.


 

The monetary policy of the UK was effective, due to the regulation of the interest rates by the central bank. As the central bank increased the interest rates, from 0.25% to 0.5%, it aimed to decrease consumption, since when interest rates increase, borrowing becomes less profitable and spending more expensive.


Figure1. The comparison of the inflation rates in the United Kingdom form 2017-2019









In 2018 the central bank increased the interest rate to 0.75% reducing the number of expenditures made by the populace since borrowing became more expensive. This resulted in the decrease in consumption and the GDP, which caused the interest rates to drop in 2018-2019.

Due to inflation being a result of economic growth and increase of money supply, as GDP decreases, the rapid growth driven by consumption becomes smaller, resulting in a decrease of money supply and decline of the inflation rate. 

For example, according to the WorldBank.com, they had a decline of 0.6% in the annual GDP during the years, as well as a reduction in the inflation rate, where it dropped for 0.82%. 


 

Furthermore, adding to the reason discussed above, monetary policy of the UK was an effective way to deal with inflation since it increased the exchange rate.

Typically, the exchange rate depends on demand for currency. As the exchange rate decreases, import becomes more expensive. It happens since from the moment of fall in pounds, less imported goods can be purchased for the same number of pounds before the fall. It causes imported inflation, thus it is necessary to increase the exchange rate.

In addition, rapid increase in imported goods’ price causes an increase in demand for domestic goods, thus increasing consumption and inflation. It proves that the exchange rate should be increased to deal with inflation.

For example, when the exchange rate was 1.22$ in 2017 inflation rate was equal to 2.56%, however when the exchange rate increased to 1.31$ in 2019, inflation became 1.74%.

 

But how could the UK increase the exchange rate?

Monetary policy should be used to increase exchange rates, since when interest rates rise, savings in pounds becomes more favored, especially for foreign citizens; higher interest rates will attract them, and it will lead to an increased demand for pounds and the exchange rate will grow.


 

However even with all its benefits, the implementation of monetary policy still had its shortcomings. The most major one of those is the lack of longevity of its effects. UK’s inflation was lower than 2% target in 2019 and 2020, however it rose greatly higher than the country's target in 2021. It happened since the central bank’s action alone couldn’t deal with high inflation without the government's support. 


Figure4. Inflation rate of England for 30 years


The United Kingdom didn’t use fiscal policy that would help them increase the government's budget. Controversially, the UK government's spendings increased, while taxes remained the same. It directly affected the increase of the country's GDP, leading to inflation rise. Hence, increasing government spending and not implementing fiscal policy is a reason for monetary policy having only short-term effects.

Nevertheless, monetary or fiscal policy couldn’t control consumption or investment during the coronavirus, since it was an unexpected turn of events, when economic growth wasn't the main priority of the government.


In conclusion, monetary policy was an effective way to deal with inflation, despite the global crisis due to Covid-19. Monetary policy helped the UK reach its macroeconomic goal of inflation of approximately 2% by decreasing consumption and increasing exchange rates.


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