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Monetary Policy in the UK

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Table of Contents

Monetary Policy

1.1.

Introduction.......................................................................................................................3

1.2.

Problem Statement............................................................................................................3

1.3.

Institutional and Historical Context..................................................................................4

1.4.

Literature Review and Policy Implications.......................................................................5

1.5.

Conclusion........................................................................................................................7

References....................................................................................................................................8

Monetary Policy

Monetary Policy in the UK

1.1.

Introduction
A monetary policy is a process through which the central bank of a country regulates the

supply of money by controlling the interest rates or other monetary instruments in order to
influence the inflation rates, to ensure the strength of the currency, and to encourage economic
growth (Mathai, 2009). The goal of a monetary policy is usually to maintain a favorable or
optimal levels of inflation and interest rates. This means maintaining a balance between
expansionary and contractionary monetary policies, where the former involves increasing the
money supply and reducing the interest rates to encourage investment and spending, whereas the
latter involves decreasing the money supply and increasing the interest rates to control high
inflation by encouraging savings.
In the UK, the monetary policy is operated and controlled by the Monetary Policy
Committee (MPC) under the independent Bank of England (BoE). The ministry of economics
and finance, the UK HM Treasury, appoints the members of the MPC and also decides the
inflation targets and objectives of the monetary policy. Hence, the monetary policy targets are
determined by the government, and BoE has an independence over the instruments of policy
control to ensure the achievement of the stated targets (Angeriz & Arestis, 2007).

1.2.

Problem Statement
It has been questioned, after the 2008-09 recession, whether the inflation targeting

framework ensures economic stability in the long run. Although the period after the 90s is righlty
known as the era of Great Moderation for its persistent stability and growth, it nevertheless

Monetary Policy

came to a bitter end with the financial crisis, which showed that the monetary mechanisms in
place were not as stable in the wake of financial shocks and that the inflation targeting did not fill
all the gaps in the macroeconomic framework. What is argued is that in the period of Great
Moderation, the financial imbalances were accumulated overtime, hidden to the policy makers
who had put too much trust in the inflation targets (UK Treasury, 2013). In this essay, we address
this problem and examine the validity of these claims and key areas of concern in the light of
research literature.

1.3.

Institutional and Historical Context


The UK HM Treasury has highlighted five monetary policy regimes since the Second

World War. The fixed exchange rate (1948-71) under the Bretton Woods was in place which
fixed the currency values between the US dollar and those of other member countries. After the
US dollars were no longer convertible into gold, bringing an end to the Bretton Woods system,
the floating exchange rate (1971-76) was in place. This period witnessed high and unstable
inflation and low output, coupled with oil and currency crises. The next phase was monetary
targets (1976-87) where the focus was to minimize and stabilize the inflation and the money
supply by controlling monetary aggregates. In the exchange rate targeting system (1987-92),
monetary policy was focused on targeting the exchange rate. The sterling was kept at a certain
balance relative to the German currency, but the exchange rate target could not be controlled for
long amid the huge influx of foreign capital. This culminated in the instability in prices and
output, along with a steep decline in the sterling. Inflation targeting (1992-97) was introduced
when the UK left the Exchange Rate Mechanism (joined in 1989) and an inflation target was
determined for its floating currency. The targets were set in a range (1-4%) with the aim to stay

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on the lower side. The decisions of the monetary policy were taken by the Chancellor. Finally,
from 1997 onwards, the IT was characterized by the independence of the BoE whereby
operational responsibilities of the monetary policy were designated to MPC (UK Treasury,
2013).
Inflation targeting (IT) monetary framework was introduced in 1992 by the Chancellor of
the Exchequer. Around that time, the inflation targets were set between 1-4%, monthly meetings
were held between the Governor of BoE and the Chancellor to decide the interest rate. The
Governor gave public advice to the Chancellor who was the final authority over the decisions on
the interest rates (Angeriz & Arestis, 2007). This monetary control system had its issues; for
example, there had been reports of disagreements between the Chancellor and the Governor
(Cobham, 2006). The new Chancellor gave independence to the BoE in 1997, and designated
the MPC to decide over the operational aspects of the monetary policy. The MPC consists of
members from the BoE, the Chancellor of the Exchequers office, and the Treasury.

1.4.

Literature Review and Policy Implications


In the recent economic settings, the monetary policy of the UK has been framed to

maintain the price stability under the inflation targeting frameworks. Inflation targeting is used
by the central banks to minimize the instability and variance in inflation and output levels in the
short run, whereas, in the long run, the aim is to ensure sustainable economic growth through
price stability. The emphasis on price stability is founded on the observation that it ensures
proper allocation of resources in the long run, while at the same time it also secures the optimal
balance between the inflation and output levels in the short run. Hence, the balance between

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these approaches, centered on price stability, is the objective of the central banks (UK Treasury,
2013).
Henry (2013) argues that the partial independence of the BoE, while celebrated, could
not avert the financial crisis that could be attributed to the errors in the conduct of the monetary
policy (Turner, 2014). He claims that the central bank was too much dependent on the inflation
targeting forecasts, assuming that this policy was the reason for stable growth and low inflation
when the evidence suggests otherwise. In addition, the policy has been a factor in increasing the
risk levels in the financial sector. This situation in the UK monetary policy was criticized also for
the lack of coordination among the concerned institutions, the tripartite system of BoE, UK HM
Treasury and the Chancellor of the Exchequer. The need for review and improvements in the IT
monetary frameworks has been recognized by the UK Treasury as well, since it has been more
than 20 years of its implementation through the BoE (UK Treasury, 2013).
However, keeping in view the price stability objectives of the IT, and its effective short
term stabilization, Bean (2007) has promoted monetary policy over the fiscal policy where the
latter should focus on the mid to long run objectives. The fiscal matters also seem to intervene
with the monetary objectives. In the political discourse, emphasis is placed on the short term
economic growth since the political objectives are dependent on the government performance,
which also shapes the political perception for the next elections (Kohn, 2014). As such, the
institutional independence may be compromised (Clerc & Raymond, 2014) but theres a need to
take it seriously. The interest groups may leverage unfair advantage by exerting influence on the
policies for short term gains, neglecting the long term consequences for the economic stability.
The policy implications of the IT monetary policy in the UK have been on the whole
pragmatically successful and positive, with some areas of concern in the management of

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financial shocks and crisis. Moreover, it is seen that the collaboration among the authority
institutions, preservation of the instrumental independence of the central bank, mitigating the
influence of the political and other interest groups, and minimizing the risk build-up in the
financial institutions are some of the areas which require further review and improvement.

1.5.

Conclusion
The monetary policy frameworks in the UK underwent various transformations since the

Second World War. In the prevailing inflation targeting mechanism, emphasis is placed on
balancing the medium term consequences of the policy measures by capitalizing on the price
statbility approach offered by the projected inflation targets, keeping in check the inflation and
interests rates along with the healthy equilibrium in the demand, while also anticipating the long
term sustainability of the progress in output and other macroenoconmic activities. Aside from the
policy framework, steps need to be taken to strengthen the monetary policy against the financial
shocks. For this purpose, as indicated in the literature, the central bank may have to be more
flexible and dynamic in pursuing its targets, with proper risk monitoring and consideration of
alternate approaches and instruments of control wherever applicable. Finally, the interest groups
needs to be recognized and controlled to ensure transparency and independence of the
institutions.

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References
Angeriz, A. & Arestis, P. (2007) Monetary policy in the UK. Cambridge Journal of Economics,
31(6), pp.863884. Available at: http://cje.oxfordjournals.org/cgi/doi/10.1093/cje/bem014.
[Accessed: 10th Aug, 2015].
Bean, C. (2007) Is There a New Consensus in Monetary Policy?, in P. Arestis (ed.), Is There a
New Consensus in Macroeconomics?, Houndmills, Basingstoke: Palgrave Macmillan.
Clerc, L. & Raymond (2014) Les banques centrales et le stabilit financire: nouveau rle,
nouveau mandat, nouveaux dfis?, Revue dconomie financire, volume 113, pp 193-214.
Cobham, D. (2006) The Overvaluation of Sterling Since 1996: How the Policy Makers
Responded and Why, Economic Journal, Vol. 116, No. 512, F185-F207.
Henry, S.G.B. (2013) U. K. Monetary Policy: Observations on its Theory and Practice U. K.
SGB Henry.
Kohn, D. (2014) Federal Reserve independence in the aftermath of the financial crisis: should
we be worried?, Hutchins Center on Fiscal and Monetary Policy. Brookings Institution.
Mathai, K. (2009) Monetary Policy. Available at:
https://www.imf.org/external/pubs/ft/fandd/2009/09/pdf/basics.pdf. [Accessed: 10th Aug,
2015].
Turner, P. (2014) The exit from non-conventional monetary policy: what challenges?, (448).
Available at: http://www.bis.org/publ/work448.pdf. [Accessed: 10th Aug, 2015].

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UK HM Treasury (2013) Review of the monetary policy framework. Available at:


https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/221567/ukec
on_mon_policy_framework.pdf. [Accessed: 10th Aug, 2015].