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Student Number: 722454

Economics (BSc)
Economic Issues (U20432)

What are the main features of


fiscal OR monetary policy in
Britain today? What have been
the major changes in the
conduct of policy since the
early 1990s?

Monetary policy is the set of arranged moves carried out by an economys central bank in
order to affect the money supply. This essay will outline monetary policy today and monetary
policy from throughout the 1990s. It will also explain how monetary policy has changed
since then, and how these changes may have affected the British economy, or why they may
have been implemented.
Having established what this essay will be about, I will now discuss monetary policy in the
UK, and give some background information. In the UK, monetary policy typically works
through the interest rate, which is the rate at which money is lent in the economy. The Bank
of England base rate (BOEBR, which may also be referred to as the bank rate), which is the
rate that the Bank of England (BOE) charges to commercial banks, is set by the monetary
policy committee (MPC). They set the bank rate and charge commercial banks this rate when
they want to borrow money. Commercial banks will only charge as low as the bank rate on
any loans they may offer, as charging a lower interest rate than this means they would lose
money. The MPC meets once a month to decide the BOEBR for the economy based on
information given to them by staff at the BOE. They set the BOEBR in accordance to
achieving the Governments 2% inflation target. However, this is not an end in itself, it is a
variable in helping the long haul security of an economy and, sustainable growth and
employment. However, the monetary policy was not always concerned with inflation.
Inflation is the change in the price level of an economy. It was not always a target of
monetary policy, inflation targeting was introduced in 1992 after the UK crashed out of the
EU Monetary Systems Exchange Rate Mechanism (ERM). The sterling had only joined the
ERM in 1990, however it was struggling to stay within the designated bands of fluctuation in
its value. When the sterling had joined the ERM, the main policy objective was to keep the
value of the sterling within the bands, this is what interest rates were aimed at, at the time.
The interest rates were used to attract foreign direct investment (FDI) in order to help control
the exchange rate. This works through the fact that higher interest rates are attractive to
savers. If the interest rate increased, then savers from other countries would want to save in
UK banks. However, they can only save in UK banks if they have sterling, thus they would
convert their money from whatever currency it was in, to pounds. This results in an increase
in the value of the pound because there has been an increase in the demand for the pound, the
market rations this excess demand by increasing the price. This process can also be carried
out inversely to push down the value of the pound. This is done by flooding the market with
pounds, by selling more pounds, this increases the supply of pounds and thus it pushes down
the price. The central bank can also be used to help maintain the value of the currency. If the
value of the pound started getting too high due to a rise in demand, the central bank would
help flood the market by creating more pounds and selling them to increase supply and
counteract the change in demand. They can also push up the value of the pound by using their
reserves of other currencies to buy pounds and increase demand and push up the value as a
result. This is what was happening in 1992, the value of the pound was falling, and the BOE
were buying as many pounds as they could with their reserve currency. Interest rates were
also raised from 10% to 12%, to 15% in an attempt to increase FDI and improve the value of
the pound. The BOE had used up the reserve currency and had failed to keep the pound
within the minimum level it was allowed to reach. The only option left for the UK was to
withdraw from the ERM. This took place on the Wednesday the 16th of September, which is
now referred to as Black Wednesday. From then onwards, the UK adopted a floating

exchange rate mechanism that allows the value of the pound to reflect changes in demand or
supply of the currency.
In October of 1992, the UK adopted an inflation target in order to replace what had been lost
with the withdrawal from the ERM. The initial targets for inflation where to be between 1%
4% until spring of 1997. During spring it would have to be between 1% and 2.5%. In the long
run, inflation had to be below 2%, however this last aim was rapidly dropped. The BOE
continued setting the interest rate under instruction from the government up until the 1998
Bank of England act which gave the BOE independence in setting interest rates. However,
according to the act, in extreme circumstances, the government has the power to instruct the
BOE on interest rates for a short period of time. The reason the BOE was given independence
was because when under control of the government, the changes in interest rates were done to
achieve the short term goals of the party in control, as they would only have the instruction
for four years at the very least. By giving them independence, they are able to carry out
changes that are aimed to be long term, rather than quick fixes. The BOE managed to keep
inflation close to its target. The average inflation rate from 1993-2013 was 2.1%, which is
only 0.1% off the target of 2%. However, in the period from 2008, the average has been
3.2%, which is relatively far off target. This is due to the global financial crisis of 2008. After
the crisis, the bank rate was cut to 0.5% in an attempt to help stimulate growth in the
economy. This low interest rate did not work in encouraging growth, and it was too low for it
to be further cut. When this happens, it is referred to as a liquidity trap, at this point is where
Quantitative Easing was introduced.
In addition to setting the bank rate for the economy, another feature of monetary policy
undertaken by the MPC is quantitative easing (QE). It can only be used when the BOE faces
a liquidity trap. This is a relatively new form of monetary policy in which the central bank of
an economy will create money electronically and use it to purchase assets, such as
government bonds, from commercial banks, pension funds, and insurance companies. These
financial institutions have accounts at the central bank, which are used as their reserves. QE
is used to increase the funds in the reserves of the financial institutions. The motivation
behind the policy is to empower banks and other financial institutions, who are the
beneficiaries of the extra money, to give it out to organisations and customers therefore
animating demand. The power to carry out QE was given to the BOE in January of 2009,
however their first purchase of assets was not made until the 11th of March 2009.

[figure 1]

Figure 1 shows the United Kingdoms inflation rate, and from the graph we can see how in
1990, inflation was almost at 10%. In the years from when the UK joined the exchange rate
mechanism and then withdrew, the inflation rate went down to approximately 2%, as seen on
the graph, from 1990-1993. From then, fluctuations in the inflation rate seem to be rather
minimal, up until 2008 where the inflation rate appears to be just under 0%, this is deflation.
However, as seen on figure 1, inflation hit approximately 5%. This is because at the time, the
cost of things such as oil, natural gas, raw materials, and food were rising.