Entries Tagged 'monetary policy' ↓

Readers Question b) Why, with the aid of these policies, the government often fails to achieve its main objectives of a healthy economic growth, full employment, price stability and a surplus on the balance of payments?

Limitations of Monetary Policy in Controlling Inflation

Cost Push Factors

If there is an increase in cost push inflation. For example, if oil prices rose signficantly, it would become difficult to control inflation and keep growth high. If cost push inflation increases, Aggregate Supply shifts to the left causing inflation and lower growth. To reduce inflation the MPC could increase interest rates. This will reduce inflationary pressure but would further reduce Aggregate Demand and economic growth. Here there is a conflict between different objectives

Time Lags

If inflation increases the MPC can increase interest rates. However, there can be a time lag of upto 18 months before higher rates have the effect of reducing demand. Therefore, it might be too late.
Therefore, there is a difficult in predicting future inflation trends.

Other Factors Affecting AD.

Higher interest rates should reduce consumer spending. However, in practice it might not. There are several factors that determine consumer spending, apart from interest rates. For example, if consumer confidence is very high and house prices are rising. Increased interest rates may be insufficient in reducing consumer spending.

• Policies for dealing with economic shocks 

Readers Question: What do you understand by the terms ‘monetary policy’ and ‘fiscal policy’? Explain with reference to a country of your choice:-

a) How these policies have been used by the government to try to achieve its objectives

Monetary policy is the attempt to control macro economic variables in an economy (primarily inflation) through the use of interest rates. - Monetary Policy
Fiscal policy is the attempt to influence the level of economic activity through changing taxation and government spending - More on Fiscal Policy

The objectives of the government are:

1. low inflation CPI=2%
2. Strong economic growth, but, not inflationary growth. Increasing long run trend rate of growth
3. reduce unemployment
4. avoid large deficit on current account balance of payments

In the UK, Monetary policy has been given to the Bank of England. Therefore, the Bank of England has independence in setting interest rates. The government only set the inflation target of 2% inflation.

Continue reading →

Readers Question: To what extent does the government influence the monetary policy commitee when they set the interest rate?

• In the UK, The Monetary Policy Committee has independence in setting interest rates.
• The government appoint members to the MPC. In theory they could appoint members who are more sympathetic to the ‘government’s point of view’. In practice they don’t. Nor do the government threaten to remove members for choosing a certain monetary policy.
• The government set the inflation target currently CPI = 2% +/- 1. In theory the government could change the inflation target or remit of the MPC. In practise they haven’t. However, if there was a serious economic shock. e.g. rising oil prices causing cost push inflation (stagflation - rising inflation and rising unemployment) some governments may be tempted to raise the inflation target from say 2% to 4%. In effect this is telling the MPC not to increase interest rates. In practise I think governments would have difficulty getting away with this. - Markets would soon lose confidence in monetary policy.

Continue reading →