Economic Assignment: Inflation, Interest Rate and Monetary Policy Committee in UK

This economic assignment discusses the dynamics of inflation, interest rate and monetary policy committee in UK. It explains the concept of real interest rate and the role of MPC in controlling inflation. It also analyzes the risk of deflation, demand side policy responses of Global Financial Crisis and impact of rising value of pound on aggregate demand. The assignment includes tables and figures to support the analysis.

Running Head: ECONOMIC ASSIGNMENT
Economic Assignment
Name of the Student
Name of the University
Author note

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Table of Contents
Introduction......................................................................................................................................2
Real interest rate..............................................................................................................................2
Role of Monetary Policy Committee in controlling UK inflation...................................................3
Risk of deflation in UK economy....................................................................................................5
Demand side policy responses of Global Financial Crisis..............................................................7
Impact of rising value of pound on aggregate demand....................................................................8
Conclusion and Recommendation.................................................................................................10
References......................................................................................................................................12

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Introduction
The case study is prepared based on the dynamics of inflation, interest rate and monetary
policy committee on United Kingdom. Monetary Policy Committee of Bank of England is
responsible for designing monetary policy in the economy. The committee is ready to adjust the
interest rate in line with fluctuation in the price level. In the phase of rising inflation, the
committee raises interest rate while during a declining phase of inflation MPC sets the interest
rate to a low level. Given a relatively low inflation rate, MPC currently does not have any
pressure for raising inflation rate. The case study discusses the concept of real interest rate along
with assessing the role of MPC in controlling inflation. Additionally, the demand side policy
responses of GFC and likely impact of a rise in value pound in aggregate demand is analyzed to
draw a firm conclusion regarding current state of economy.
Real interest rate
Interest rate represents the charge on borrowed fund. The nominal interest rate is the
interest rate that does not consider inflation rate into account. The inflation however affects the
effective rate of interest and hence, alters the burden of interest. During inflation, the value of
money reduces. Hence, borrower paying nominal interest rate gain while lender loses because of
a small effective return. Reverse is the case during a downward movement of price. Therefore,
inflation should be taken into consideration for evaluating real return of funds. The real interest
rate is the inflation adjusted return (Goodwin et al. 2015). The interconnection between nominal
and real interest rate and that of inflation rate is stated by the Fisher Equation given as
Real interest rate=Nominal interest rate−inflation rate

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Real interest rate is a tool to understand the nature of monetary policy. A low real interest rate
indicates that a stimulatory monetary policy while a high interest rate implies prevalence of a
tight monetary policy.
Role of Monetary Policy Committee in controlling UK inflation
The monetary policy committee of UK has the responsibility to meet an inflation target.
The committee aims to maintain a targeted inflation rate of 2%. The monetary policy committee
design monetary policy to stabilize price and provides confidence to the currency. The
committee has faced some difficulty in achieving its inflation target in recent years. After the hit
of global recession UK CPI inflation is average at 3%. In December 2013, the inflation backed to
the level of 2% (bankofengland.co.uk 2018).
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
0
1
2
3
4
5 4.48
2.83 2.53
1.47
0.05
0.64
2.69 2.71
Average inflation
Year
Average inflation (%)
Figure 1: Inflation in UK since 2011
(Source: inflation.eu 2018)
The figure above shows the movement of price level in UK since 2011. After the global financial
crisis, because of unstable economic condition inflation has reached to a level of 4.48%, above
than the inflation targeting. Since 2011, inflation rate started to decline and become as low as

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0.05% in 2015. In recent years, inflation has accounted a slightly increasing trend mainly due to
depreciation of pound and resulted increase in import price.
Figure 2: UK bank rate over the years
(Source: bankofengland.co.uk 2018)
The main instrument used to control inflation is the interest rate. The figure above shows
the trend in UK base interest rate. For a prolonged period of 2009 to 2016, the inflation rate has
remained unchanged at 0.5 percent. In response to a very low inflation rate of 0.05%, the
committee reduced the bank rate to the lowest level of 0.25 percent to provide necessary stimulus
to the economy (Hanson and Stein 2015). The price level then recovered and reached to the level
of 2.69%. The interest has again revised to set at its earlier stable rate of 0.50%.
The price level in UK often experiences temporary shocks from domestic and
international market. For example, a fall in sterling, global energy price shock and an increases
in VAT increases contributed to an increase in the inflation rate in UK over four years. The
impact of such temporary global shocks are generally accommodated by the monetary policy
framework. The second round effect of such shock in developing inflation expectation or wage
settlement is not relevant in context of UK economy (assets.publishing.service.gov.uk 2013).

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The flexibility of MPC to allows price level to deviate from target level flowing temporary
shocks enhances credibility of the committee to maintain medium term price stability anchoring
inflation expectation. The stable inflation and a low base rate currently indicates MPC has no
pressure to increases the interest rate. The committee however is ready to make an upward
revision of the interest rate if price level accounts an increase.
Risk of deflation in UK economy
The phenomenon of a continuous decline in price level is termed as deflation. Deflation
becomes an economic concern when the movement in price level is associated with price of long
term asset and is built into the expectation of policymakers. In recent years, UK has experienced
a decline in value of pound against most of its trading partners ((Cloyne and Hürtgen 2016). The
depreciation of currency increases price of the imported goods. The main indicator of inflation,
consumer price index in UK is rising. The declining price of fuel helps to offset price increase
commodities of basic need like food, clothes and other necessary household good.
Figure 3: Percentage change in Consumer Price Index since May 2015
(Source: ons.gov.uk 2016)

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The inflation in UK has remained at a low level. In the last 60 years, the average inflation
rate in UK stays around 5.5%. The inflation targeting has become one of the top priority of
government. The continuous effort of government has kept the interest rate to a relatively low
level 2.6% (theconversation.com 2018).
Figure 4: Percentage change in Consumer Price Index since 1989
(Source: ons.gov.uk 2016)
Objective of Bank of England is to maintain the inflation at around 2%. The main drivers
of soaring inflation in recent years is the depreciation of sterling. Price though estimated to be
higher but will be stable. During deflation prices in the economy fall imposing a restriction to
long term growth. The deflation potential for UK economy is evident. The Brexit referendum is
expected to have a long term adverse effect on household income and disposable income. The
Brexit thus hitting consumer spending has a high chance to drag the price level to an unexpected
low level creating concern for Bank of England and Monetary Policy Committee.

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Demand side policy responses of Global Financial Crisis
During economic shocks a set of demand and supply side policies are undertaken to
combat the recessionary effect. In response to global financial crisis UK government took a
several policies to provide necessary stimulus to the economy. In times of the crisis, the UK
economy required effective fiscal action to boost aggregate demand. Tax and government
expenditure are the two fiscal policy tools. During 2008, the government announces a tax cut of
£145 on basic rate for the taxpayers. The tax exemption was applicable for taxpayers earning an
income of £34,800 per annum. On the sales tax a temporary rebate of 2.5% was given for value
added tax (Wanna, Lindquist and De Vries 2015). Government also focused on increasing tax
investment spending. A £3 billion worth of investment was announced from 2010 onward.
Government had launched different schemes such as Small Enterprise Guarantee Scheme. The
estimated government expenditure for these various measures roughly equal £20 billion. An
additional £5 billion spending as made for conducting training program in order to help young
unemployed people.
Figure 5: Effect of demand side policy responses

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(Source: as created by Author)
The economic growth and price level in the economy is determined from the balance
between aggregate demand and aggregate supply (Uribe and Schmitt-Grohé 2017). AD and AS
curve respectively represents the aggregate demand and aggregate supply. Now, expansionary
fiscal policy to boost demand shifts the aggregate demand curve outward. The aggregate demand
curve shifts rightward from AD to AD1. The new equilibrium is at E2. E2 is associated with a
higher output Y2 and a higher level of price to P2.
The limited ability of UK government to take discretionary fiscal policy action resulted in
significant debt burden for the government. The government debt has estimated to be £175
billion accounting 12.4% of GDP. The net borrowing of government during 2014-14 was £102.3
billion (Bhattarai, Haughton and Tuerck 2015).
Figure 6: National Debt of UK
(Source: ons.gov.uk 2016)
Impact of rising value of pound on aggregate demand

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Aggregate demand in an economy the sum demand generated from different sectors of
the economy. It is represented as the sum of expenditure made in a given year. The four
principle component of aggregate demand are consumption expenditure, investment expenditure,
government expenditure and net export. Net export represents the balance of trade and obtained
as earnings from export less spending on import (Gandolfo 2016). Factors causing change in any
of these causes a change in the aggregate demand. The volume of trade and hence, net export
depends on the relative value of the currency. An increases in the value if currency reduces the
price of import while making export more expensive. Opposite is the case for a decline the value
of currency.
Aggregate demand curve depicts the relation between national output and corresponding
level of price, any change in aggregate demand causes national output and price level of change.
The increase in the value of pound implies home currency of UK has become expensive relative
to foreign currencies. This benefits UK citizen to enjoy a cheaper price of the import. The
currency appreciation however hurts the export sector by reducing increasing relative price of
UK export in the world market. Increase in import along with a decline in export reduces net
export of UK. A decline in net export in turn causes a decline in aggregate demand shifting the
aggregate demand curve to the left (Bernanke, Antonovics and Frank 2015). The likely impact of
this is shown in the following figure.
The MPC thus should be concerned with potential implication of Brexit. A much bigger
concern for persistent fall in price is creation of spare capacity in time of deflation. This causes a
shift in expectation imposing a threat to long run growth prospects.

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Figure 7: Impact of a rising value of pound on aggregate demand
(Source: as created by Author)
As discussed above an appreciation of pound reduces the aggregate demand. This shifts
the aggregate demand curve inward from AD1 to AD2. As a result of decline in aggregate
demand, real GDP declines from Y1 to Y2 while price level fall from P1 to P2.
Conclusion and Recommendation
The monetary policy committee in UK designs monetary policy depending on state of the
economy. Current inflation target of the committee is to stabilize the price level at 2%. The
committee has maintained a low interest rate of 0.50%. Price level in an economy is vulnerable
to temporary shocks. The flexibility of MPC helps to maintain a stable state of price in the long
run bypassing the temporary shocks. At present inflation is fairly stable. Therefore, the
committee does not need to increases interest rate now. The low inflation rate has a potential for

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bringing deflation which should be taken care of. During GFC, in addition to monetary policy
stimulus fiscal instruments like tax cut, increases in government expenditure and other are used
to stabilize the economy.
The current interest rate at set a low level of 0.50%. However, too low interest rate has a
component that can itself crates an inflationary pressure. When the economy operates almost at
the level of full employment then low interest rate by MPC over stimulate the aggregate demand
beyond its capacity to react in the short run. The effect on low rates fall on price level instead of
stimulating employment and output. The Bank of England and MPC should also be aware of any
deflationary pressure that can restrict future economic growth.

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References
Assets.publishing.service.gov.uk. (2013). Review of Monetary Policy Framework. [online]
Availableat:https://assets.publishing.service.gov.uk/government/uploads/system/uploads/
attachment_data/file/221567/ukecon_mon_policy_framework.pdf [Accessed 25 Apr. 2018].
Bernanke, B., Antonovics, K. and Frank, R., 2015. Principles of macroeconomics. McGraw-Hill
Higher Education.
Bhattarai, K., Haughton, J. and Tuerck, D.G., 2015. Fiscal policy, growth and income
distribution in the UK. Applied Economics and Finance, 2(3), pp.20-36.
Cloyne, J. and Hürtgen, P., 2016. The macroeconomic effects of monetary policy: A new
measure for the United Kingdom. American Economic Journal: Macroeconomics, 8(4), pp.75-
102.
Gandolfo, G., 2016. International Finance and International Macroeconomics: An Overview.
In International Finance and Open-Economy Macroeconomics (pp. 3-9). Springer, Berlin,
Heidelberg.
Goodwin, N., Harris, J.M., Nelson, J.A., Roach, B. and Torras, M., 2015. Macroeconomics in
context. Routledge.
Hanson, S.G. and Stein, J.C., 2015. Monetary policy and long-term real rates. Journal of
Financial Economics, 115(3), pp.429-448.
history, O. (2018). Bank Rate | Bank of England Database. [online] Bankofengland.co.uk.
Available at: https://www.bankofengland.co.uk/boeapps/database/Bank-Rate.asp [Accessed 25
Apr. 2018].

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Media, T. (2018). Historic inflation Great Britain – historic CPI inflation Great Britain. [online]
Inflation.eu. Available at: http://www.inflation.eu/inflation-rates/great-britain/historic-inflation/
cpi-inflation-great-britain.aspx [Accessed 25 Apr. 2018].
Ons.gov.uk. (2016). RPI All Items: Percentage change over 12 months: Jan 1987=100 - Office
for National Statistics. [online] Available at:
https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/czbh/mm23 [Accessed 25
Apr. 2018].
Policy, M. (2018). Monetary policy | Bank of England. [online] Bankofengland.co.uk. Available
at: https://www.bankofengland.co.uk/monetary-policy [Accessed 25 Apr. 2018].
The Conversation. (2018). Should the UK be worried about inflation? No – looming deflation is
the real concern. [online] Available at: https://theconversation.com/should-the-uk-be-worried-
about-inflation-no-looming-deflation-is-the-real-concern-82619 [Accessed 25 Apr. 2018].
Uribe, M. and Schmitt-Grohé, S., 2017. Open economy macroeconomics. Princeton University
Press.
Wanna, J., Lindquist, E.A. and De Vries, J. eds., 2015. The Global Financial Crisis and Its
Budget Impacts in OECD Nations: Fiscal Responses and Future Challenges. Edward Elgar
Publishing.