Question 3

Describe the types of monetary policy, using concepts from Block 5, Reading 41. Identify the kind of monetary policy that the Bank of England has adopted, using concepts from Block 5, Reading 41 and evidence presented in Case Study II. (25 marks)

Question 4

Evaluate the expected economic effects of the interest rate cuts by the Bank of England on the UK economy facing the coronavirus crisis, using information from Case Study II and concepts discussed earlier in question 3.

Case Study - II

Bank of England cuts interest rates to all-time low of 0.1%

Rishi Sunak will reveal plans to subsidise workers' wages to prevent hundreds of thousands of lay-offs on Friday as the Treasury comes under pressure to match the new Bank of England measures to limit the economic fallout from Covid-19.

Amid warnings from the Trades Union Congress (TUC) that time is running out to save jobs from being axed, the chancellor is understood to be working on the final details of the scheme, including how many workers should be covered, how long it should last for and how it should be delivered.

Sunak met the leaders of the TUC, the British Chambers of Commerce and the Confederation of British Industry as the bank cut interest rates to 0.1%, their lowest ever level, and launched a fresh 200bn money creation scheme.

The bank cut interest rates to an all-time low and increased its quantitative easing (a way of injecting new money to stimulate the economy) stimulus package following further panic in financial markets over the handling of the coronavirus outbreak.

The Bank made the decision at a special meeting of its rate-setting monetary policy committee on Thursday. It will also buy an additional 200bn of UK government and corporate bonds under a Quantitative Easing money-printing programme, designed to hold down the cost of borrowing and pump cash into the economy.

The Monetary Policy Committee at a special meeting on 19 March voted to cut bank rate to 0.1% and increase its holdings of UK government and corporate bonds by 200 billion.

It comes a week after the Bank cut rates from 0.75% to 0.25% to address the coronavirus crisis and adds to the pressure on Sunak to put forward further measures to prevent mass job lay-offs.

The chancellor is trying to finalise the details of a plan that would allow employers to put workers on part-time hours or lay them off without them losing all their income.

But plans to run a new compensation scheme through the computer systems at HMRC and the Department of Work and Pensions have faltered after it became clear the scale of the changes breached the capacity of both government departments.

The Bank of England governor, Andrew Bailey, said the central bank moved quickly to calm markets spooked by the growing number of deaths from Covid-19 and concerns that the world's major economies are likely to suffer the steepest falls in GDP since the 2008 financial crash.

Rumours that London would be forced into complete lockdown imminently had also played a part in panicking financial markets. "You could see that reflected in the rising value of the dollar, in bond yields and in bond spreads," Bailey said.

"The obvious increase in the pace and severity of Covid-19, which has built during the week, was something we had to assess and respond to, we can't wait for the hard economic data before we act," he added.

Bailey said he would use the extra 200bn of quantitative easing funding to act in the markets promptly, adding that all central banks were moving in the same direction. "I talk to central bank governors most days and while we make decisions with reference to our own mandates, it is not a surprise that we all are coming to the same conclusion over what to do."

Central bank officials are known to be nervous about a collapse in business and consumer confidence after a spike in the number of virus cases and deaths in the UK.

Speculation that ministers are close to announcing further spending commitments to underwrite workers' incomes, with vast extra borrowing needed to fund it, is also believed to be behind the move.

The pound rose in value after the announcement, having endured its fifth worst day of the century against the US dollar before falling back to 1.16 against the US dollar. Only 10 days ago sterling was valued at $1.30. The pound was also up 2.4% against the euro at (EURO)1.0887.

Britain's blue chip share index, the FTSE 100 leapt almost 200 points following the move to close up 1.4% at 5,152. Continental stock markets followed the upswing with the German Dax closing up 2% while the French CAC rallied 2.7%.

Oil prices also recovered, adding more than $3 a barrel or 12.5% to the price of Brent crude, which reached $30 per barrel.

The Bank of England move follows the creation of a (EURO)750bn (637bn) emergency fund by the European Central Bank to extend its bond buying programme and shore up sovereign and corporate debt eurozone.

Bailey said that without the Bank of Englands rate cut and stimulus package it was likely the volatility seen in markets over recent days would have worsened.

Replying to suggestions that the central bank had used all its ammunition to support the economy, he said: "We are not done. The Bank of England will do what the public needs in the days and weeks ahead."

Analysts at Japanese investment bank Nomura said the cut in interest rates and boost to quantitative easing was "highly unlikely to prevent a sizeable hit to [UK] Gross Domestic Product this year", but they added "there can be no question that the monetary and fiscal authorities are throwing everything they can at this problem to support firms and households, cushion demand as much as is reasonably possible, and to reduce the long-term hit to supply".

Karen Ward, a senior analyst at JP Morgan Asset Management, and a former Treasury adviser, said: "It is the additional quantitative easing in today's Bank of England package that will have the most significant impact, both in terms of the market reaction but also a solution to the economic challenges presented by Covid-19.

Ward added: "The support to the economy and health system will require vastly higher government borrowing. The central bank showing willing to buy government debt will ensure the market can absorb this additional issuance without undue stress.

(Source: Monaghan and Inman, 2020)

Monetary policy As you have seen, aggregate supply and demand can be influenced by fiscal policy. However, this is not the only economic policy that can be used to influence the economy. Monetary policy deals with the supply of money and it is primarily based on the setting of interest rates. It is not usually pursued by governments directly, but by central banks, although this is not always the case; for example, the Bank of England was not independent in respect to monetary policy until the late 1990s.

A central bank can be thought of as a bank of central government. It is the monetary authority responsible for overseeing the monetary system for a nation (or group of nations). A very well-known example ofacentral bank is the European Central Bank (Figure 5) (which is, of course, an example of a central bank that is not actually a bank of central government).

Since 1 January 1999 the European Central Bank (ECB) has been responsible for conducting monetary policy for the Eurozone. The ECB is the central bank for Europe's single currency, the euro. The ECBs main task is to maintain the euros purchasing power and thus price stability in the euro area through the making and implementation of monetary policy for the euro area. Beyond monetary policy, the ECB pursues additional tasks, for example authorising the issuance of banknotes within the euro area, collecting statistical information necessary in order to fulfil its tasks, supervising the conduct of credit institutions in order to ensure the stability of the financial system, etc. The ECB was established as the core of the Eurosystem and the European System of Central Banks (ESCB). The ESCB comprises the ECB and the national central banks (NCBs) of all EU Member States whether they have adopted the euro or not.

A central bank is different from other banks because it has the unique power of issuing banknotes and coins of a given currency. (You may have heard about the popular concept of printing money as a key role of central banks.) The Swedish Riksbank (founded 1656) and the Bank of England (founded 1694) were the first central banks to be established in Europe. A central bank controls the overall amount of money available in the economy and it has a wide range of responsibilities, such as regulating and overseeing the banking system, implementing monetary policy, overseeing currency stability, and promoting low inflation and full employment. Most central banks are owned by their respective governments (e.g. Blanchard and Johnson, 2012; Burda and Wyplosz, 1993). Similarly to fiscal policy, there can also be an expansive or a restrictive monetary policy. An expansive monetary policy aims to increase the amount of money supplied by reducing interest rates. Expansive monetary policy is usually implemented during periods of economic recession. A central bank sets an interest rate at which it lends to other financial institutions. This interest rate is normally called the base rate and it affects the whole range of interest rates set by commercial banks and other financial institutions for their own savers and borrowers (Bank of England, n.d.). In the case ofareduction in interest rates, it should make saving less attractive and borrowing more attractive for businesses and consumers, which should stimulate spending and increase demand. A reduction in interest rates also reduces the cost of loans to business and can therefore stimulate firms to increase borrowing and make investments in order to increase production and meet increased consumer demand. Monetary policy is primarily based on influencing the demand and supply of money by setting interest rates; however, central banks may also use other policy tools. Quantitative easing is an example of such a policy tool. It involves the printing of new money issued by the central bank for the purchase of government bonds (a bond issued by a national government, generally with a promise to pay periodic interest payments and to repay the Readings 3745 72 face value on the maturity date). This is a way of injecting new money (liquidity) into the economic system with the aim of increasing the circulation of money and lowering the cost of borrowing. Quantitative easing was used by both the US and UK central banks to stimulate the economy after the global financial crisis of 2008. Quantitative easing is quite a complex subject and you dont need to get to grips with its details at this stage in your studies. However, it is worth being aware of it as a monetary policy tool as it has been used extensively by governments in the wake of the 2008 global financial and economic crisis (see more in the article in Exercise 2 below) and the term was used a lot in the news in the years to follow. A restrictive monetary policy is characterised by an increase in interest rates. This will reduce the money supply and therefore make it less profitable to invest and produce. Restrictive monetary policies aim to reduce inflation. For example imagine that people are doing well and are in the mood to spend. It may be, however, that the economy is not geared up to meet this increased demand. As a result, prices and inflation start to rise. In this situation a central bank may decide to make borrowing more costly by raising interest rates. As a consequence, banks will normally charge higher interest rates to their customers, reducing the amount they are able to spend and thus consumer demand. An increase in interest rates may also encourage inflows of money from abroad as international investors look for the most profitable investments. Such an influx of foreign money will appreciate the value of the domestic currency, but it will make exports of domestic goods relatively less competitive. Of course it is very difficult to predict precisely what the impact of changes in monetary policies will be or how long it will be before they take effect. The main effects of a rise or decrease in the interest rates can take up to about two years to be felt (Bank of England, n.d.). Accordingly, central banks set interest rates based on judgements about what inflation might be over the next few years. Summing up, for businesses lower interest rates mean reduced costs of financing the business, thus stimulating demand for money. Individuals with mortgages or other loans at variable rates also benefit from reduced interest rates because they will pay less interest on these loans and mortgages. All these effects should increase the circulation of money, boosting economic growth. In contrast, higher interest rates are set in order to reduce inflation and maintain price stability. They impact on businesses through increased costs of borrowing, which lead to reduced investment. Consumers may also spend less as they find it more expensive to borrow money and/or may be more tempted to save rather than spend their money. This reduced demand by businesses and consumers is likely to lead to lower prices, thus stopping or reducing inflation.