?Examine the effectiveness of the Bank of England, the ECB, the Federal Reserve or any other central bank that you are familiar with in dealing with the problems of inflation and deflation (30) Central banks have strong influences on the rates of inflation and deflation through the adjustment on interest rates. The monetary policy committee (MPC) are a committee of the Bank of England who meet every month to decide the office interest rate of the United Kingdom, something of which has great effects on the inflation and deflation seen in the country.
The first effect of which the change in interest rates set by central banks has is through the change it has on asset prices. If there was a rise in interest rates, there’d be an increased return on savings in banks and bulding societies, which in turn may encourage savers to invest less in certain assets such as houses and shares. This drop in demand will slowly accumulate as more investors turn to saving for a cheaper, more guaranteed return on their money. This will have an effect on the RPI rate of inflation, however not the CPI (the rate the BofE base their interest rates on -2% target) as the CPI doesn’t include asset price changes.
However there still may be a knock on effect of a change in asset prices on the CPI rate of inflation. This is because the drop in asset prices will reduce the wealth of individuals holding such assets which, in turn, will influence their willingness to spend on goods which affect the CPI. Possibly the biggest effect on demand that the interest rates set by central banks have on inflation and deflation is the effect it has on spending and saving habits as a result of change in cash flows. Interest rates will affect the attractiveness of spending today relative to spending tomorrow.
Lowered rates will cause borrowing to increase, cuasing current spending by both consumers and firms to rise. This will mean inflation to pick up as demand rises so will be useful during times of deflation of low inflation in order to attempt to get within the bounds of the 2% target. On the other hand, higher interest rates will cause a drop in demand and spending as for savers the return on their investment will be higher. However it also means higher interest rates for people and firms with current debts who are being charged using variable interest rates.
This is not always the case however, as there may be a couple years gap before debtors pay the higher interest rates due to them taking out a fixed rate mortgage. The effect on mortgages rates will be similar to that found with assets – if interest rates decrease then there will be an increase in effective disposable income of homeowners with variable-rate mortgages and subsequently stimulation of consumer spending will occur and there should be a rise in inflation. Another particular influence on prices comes through the exchange rate.
If the Bank of England raise their interest rates higher relative to those in other countries then it is likely that as a result there will be an increase in the amount of funds flowing into the UK, as the higher interest rates attracts investors. This will usually cause an appreciation of Sterling against other currencies. In effect, the rate of sterling can be affected both before and after a rise in interest rates has actually occurred. This is because there will be some influence from expectation of future interest rates, so investors may increase the amount they invest into sterling before rates actually rise.
The appreciation of sterling will reduce the price of imports and subsequently will cause inflation to fall as many imported goods are included on the CPI. If there is a fall in investment and consumer spending, as well as dropping interest rates, the MPC also invest in assets using money that the bank of England has created electronically. This process is called quantitative easing and is aimed at boosting inflation to keep inflation on track to meet its 2% target, it is mainly government bonds of which they purchase.