4.2.4 Financial markets and monetary policy

How does monetary policy work? Explain how monetary decisions affect main macroeconomic outcomes such as the nominal GDP and inflation? [Essay Competition]

Monetary policy is used by central banks to try to achieve macroeconomic outcomes: stable and sustainable economic growth, levels of inflation around 2%, low rates of unemployment and equilibrium on the balance of payments of a nation. Founded in 1694, the UK’s central bank, the Bank of England, through regulating the supply of money and interest rates, aims to achieve the former objectives. There are two types of monetary policy: expansionary, which is used to stimulate economic growth, and contractionary, which is used to reduce inflation and stabilise the economy. My essay shall initially explore what the macroeconomic outcomes are, explain how monetary policy operates and then will proceed to connect both points together.

Economic growth is arguably the most important macroeconomic outcome, as it drives improvements in living standards, creates jobs, and lays the foundation for other critical objectives like price stability, fiscal health, and poverty reduction. Growth provides the resources necessary for governments to invest in public goods such as healthcare, education, and infrastructure, further enhancing societal welfare. The UK, for example, experiences annual growth of around 2.5%, doubling its economic output every 28 years under the rule of 70, used to find a doubling period]. This consistent growth leads to higher incomes, better access to essential services, and greater opportunities for social mobility (although there may be a few arguments suggesting that we are falling behind). Economic growth also enables governments and businesses to make long-term investments that benefit society. During periods of growth, governments can allocate funds to improve public infrastructure, which not only boosts economic efficiency but also enhances quality of life for all citizens. Similarly, businesses can reinvest their profits into research and development, driving innovation and productivity improvements in capital and labour that benefit the broader economy.

Improved economic growth can also lead to positive externalities by creating broader societal benefits, such as better infrastructure, increased employment, and higher productivity. For example, the UK’s £10 billion green recovery plan in 2020, part of an effort to align growth with Environmental, Social, and Governance (ESG) goals, shows how economic expansion can foster sustainability. As the economy grows, governments and businesses gain more resources to invest in green technologies, which can reduce pollution, mitigate climate change, and improve public health—positive externalities that benefit society. This growth also encourages businesses to adopt sustainable practices, such as renewable energy use, while adhering to ethical labour standards, promoting social welfare, and responsible governance.

The environment, as a common good, is a resource shared by all but often subject to overuse and degradation, a situation known as the "tragedy of the commons." Without proper management, individual incentives can lead to environmental harm. However, economic growth and ESG initiatives can help address this by incentivizing collective action to protect the environment. Thus, economic growth not only boosts fiscal health but also supports long-term sustainability and social well-being through both direct and indirect benefits, while(potentially) counteracting the tragedy of the commons.

Inflation is another crucial outcome, as it affects purchasing power, the cost of living, and economic stability; moderate inflation, around 2%, signals healthy, sustainable demand and growth, encouraging investment and consumption. There are two types of inflation. The Covid-19 pandemic, for example, caused cost-push inflation through exogenous (supply chain) disruptions such as rising manufacturing costs, damaging the purchasing power of fixed-income earners and savers. Demand-pull inflation occurs when excessive demand outpaces supply, pushing prices up. High inflation erodes real wages, reduces purchasing power, and discourages investment, leading to economic uncertainty; this is particularly harmful for those with fixed incomes or cash savings. According to the Phillips Curve, there is often a trade-off between inflation and unemployment in the short run. Excessive inflation can even lead to stagflation, where rising prices coincide with stagnant growth and high unemployment, making it essential to maintain inflation at a sustainable level to ensure long-term stability and confidence in investment and savings. Therefore, while moderate inflation may reflect a growing economy, unchecked inflationary pressures can disrupt this balance, leading to negative consequences like reduced consumer and business confidence, lower investment, and higher unemployment. Policymakers must carefully manage inflation to avoid these destabilising effects and ensure both sustainable growth and stable employment.

A stable current account balance is another key objective, reflecting the balance between a country’s exports and imports. A surplus indicates a net exporter, while a deficit means borrowing from abroad to fund imports. Persistent deficits can lead to external debt and currency depreciation, while a surplus may provoke trade protectionism. Maintaining a stable current account ensures manageable external transactions, avoiding excessive borrowing or reliance on foreign financing.

Unemployment is a critical indicator, as high levels signal inefficiencies and underutilisation of labour. It can reduce consumer spending, tax revenues (both direct and indirect), and increase welfare costs, as those who are unemployed have less disposable income thus spend less and often have to rely on benefits. Structural unemployment, caused by skill mismatches, can persist even in growing economies, requiring targeted policies. Cyclical unemployment rises in downturns and falls with economic expansion. There is also seasonal and frictional but are less important to an economy. After the 2008 financial crisis, UK unemployment peaked at 8%, but with sustained growth, it fell to 3.8% by 2019. Reducing unemployment is vital for maximizing productive potential and improving living standards.

Economic growth presents trade-offs with other objectives. For example, it can lead to inflationary pressures when demand exceeds supply or worsening the current account deficit if consumer spending drives up imports. Reducing government deficits by cutting spending or raising taxes may slow growth, while high periods of growth can create negative externalities like pollution. Lastly, there’s a short-term trade-off between unemployment and inflation, as growth reduces unemployment but may push inflation higher.

Monetary policy plays a pivotal role in managing these macroeconomic outcomes through various tools. I shall now move on to how monetary policy helps achieve the outcomes mentioned earlier.

Open market operations (OMO), a tool used by central banks to buy or sell government securities to regulate the money supply. The Bank of England makes these trades with other banks to influence the bank rate, the key interest rate that guides borrowing costs. This rate then passes through the transmission mechanism, which is the process through which changes in the central bank's interest rates impact the broader economy. When the Bank of England adjusts its rates through OMOs, it affects commercial banks' lending rates, asset prices, and exchange rates, which in turn influence consumer and business spending.

There are two main ways that OMO policy impacts macroeconomic outcomes. Buying government securities injects money into the circular flow of income, boosting consumption and aggregate demand (AD). This approach is particularly useful during recessions, where the initial injection can trigger the multiplier effect, reduce unemployment, and spur economic growth. For example, during the 2008 financial crisis, the Bank of England lowered interest rates from 5.5% in 2007 to 0.5% by March 2009, one of the steepest cuts in its history. Additionally, the BoE implemented quantitative easing (QE), by purchasing £375 billion in government bonds (gilts) by 2012 to stimulate economic activity. These actions were crucial in helping stabilize the economy, contributing to a recovery in GDP growth, which went from contracting by 4.2% in 2009 to growing by 1.4% in 2010. In times when AD is near full capacity, buying securities can increase demand-pull inflation, helping the central bank reach its inflation target.

Conversely, selling government securities is a withdrawal from the circular flow of income, reducing consumption and AD. This can be particularly useful when the economy has an unsustainable positive output gap, and the central bank wants to reduce cost-push inflation. A recent example is 2022, when UK inflation surged to 11% due to rising energy prices, supply chain disruptions, and increased demand following the pandemic. In response, the BoE used OMOs to tighten liquidity, reducing the money supply to control inflation. These measures helped slow the rise in inflation, bringing it down from its peak. This approach aimed to manage inflationary pressures and support long-term price stability; a somewhat successful macroeconomic outcome implemented by the BoE.

Bank rate. I was fortunate enough to visit the BoE on December 19th, 2024, when rather coincidently It was the last time, that the BoE changed the Bank Rate to 4.75%. But what even is the Bank rate? The Bank Rate is the interest rate at which commercial banks borrow from the central bank. It is one of the most direct tools for influencing economic activity; the BoE adjusts the bank rate to control inflation and stimulate or slow down the economy. Lower interest rates boost nominal GDP by incentivizing borrowing for consumption and investment. For example, during the Covid 19 pandemic, the BoE slashed the bank rate from 0.75% in March 2020 to 0.1% in just a few weeks to stimulate economic activity. This was essential to offset the collapse in demand caused by lockdowns and restrictions. At the same time, the BoE implemented further quantitative easing (QE), raising its bond-buying program to £895 billion by November 2020. These measures helped to prevent a sharp contraction in economic activity. Although the UK economy contracted by 9.9% in 2020, GDP growth rebounded strongly to 7.5% in 2021, aided by the BoE’s interventions. Lower interest rates during the pandemic also helped keep unemployment in check, as businesses were able to access cheap credit to avoid mass layoffs. The unemployment rate peaked at 5.1% in 2021, much lower than the anticipated levels of over 10%, demonstrating the BoE’s success in stabilising the labour market.

Central banks can also have an influence on how much commercial banks can lend by adjusting the reserve requirement ratio; a percentage of customer deposits that banks hold as reserves. A lower reserve requirement increases the funds that are available for lending, increasing consumption and investment (access to credit increases) which boost aggregate demand. This, in turn, increases economic growth, improving living standards, life expectancy and literacy rates as well. Literacy rates are important as this reduces structural unemployment in the long run and hence also the natural rate of unemployment as well. An increase in investment may also make domestic firms more competitive, leading to an increase in exports as well. This will reduce the current account deficit (which is more important for long term growth). Although the BoE does not use reserve requirements as actively as other central banks (such as the Federal Reserve of America), this tool is still a key mechanism for controlling liquidity in banking systems worldwide.

Paul Krugman’s book, The return of depression economics, refers to the Asian financial crisis where the Bank of Thailand reduced its reserve requirement ratio from 13.5% to 6% to address a severe liquidity crunch. This policy injected additional funds into the banking system, allowing commercial banks to increase lending to struggling businesses and consumers. As a result, despite the baht losing nearly 50% of its value, Thailand's economy began to recover by 1999, with GDP growth rebounding to 4.2% after contracting by -10.5% in 1998. This demonstrates how lowering reserve requirements can play a crucial role in economic stabilisation by increasing liquidity and preventing a deeper recession.

A central bank can also intervene in foreign exchange markets to manage the value of its currency, which directly impacts inflation and GDP. By buying or selling foreign currencies, central banks can influence exchange rates, which affect the current account balance. A strong British pound makes UK exports more expensive and imports cheaper, leading to a higher current account deficit as domestic consumers buy more foreign goods while foreign demand for UK exports declines.

Additionally, a strong pound has deflationary effects by reducing the price of imported goods and services, as a higher exchange rate makes foreign goods cheaper for domestic consumers. This increases the marginal propensity to import (MPI) since lower import prices encourage UK consumers to buy more foreign goods. At the same time, cheaper imports help curb imported inflation, a key component of overall inflation. For example, if the Bank of England intervenes to strengthen the pound, the cost of essential imports like oil and food decreases. This, in turn, lowers production costs for businesses and consumer prices, contributing to overall deflationary pressure.

Conversely, if the pound weakens, exports become more competitive internationally, stimulating demand for UK goods. However, a weaker pound also increases the price of imports, contributing to higher cost-push inflation. A clear instance of this occurred following the Brexit referendum in 2016, where the pound depreciated significantly falling by 15% against the US dollar. This depreciation led to a rise in inflation, from 0.5% in June 2016 to 3% by the end of 2017, driven by increased import costs. This dual impact shows how foreign exchange interventions can balance the trade-off between stimulating GDP growth through export competitiveness and controlling inflation via import prices. Central banks, therefore, carefully weigh these factors when considering currency interventions.

In conclusion, monetary policy is very important for achieving key macroeconomic outcomes like stable growth, controlled inflation, and employment stability. Through tools such as open market operations, the bank rate, and foreign exchange interventions, central banks can effectively respond to short-term challenges and guide the economy toward balance. However, while monetary policy is essential, it cannot fully address structural issues such as inequality or infrastructure gaps. This is where fiscal policy comes in which, through government spending and taxation, complements monetary measures by driving long-term development and addressing broader societal needs.

In my opinion, monetary policy’s strength lies in its adaptability to manage immediate economic fluctuations, making it in crucial in stabilising nominal GDP and inflation during the “boom and bust” cycle. However, its effectiveness hinges on alignment with fiscal measures to ensure a comprehensive approach to economic management. As Milton Friedman once stated, "Inflation is caused by too much money chasing too few goods," emphasising the importance of central banks in maintaining equilibrium in an ever-changing economic landscape.