Monetary policy Essay Example

Between 1945 and the end of the 1960s the primary tool used to control the economy was fiscal policy; this was during the Keynesian era and Keynesians still believe that fiscal policy coupled with reasonably steady interest rates is the right approach to take. Fiscal policy is concerned with government expenditure and taxes; the theory is that if you decrease government expenditure and increase taxes this will steady a booming economy and prevent inflation from escalating out of control, lessening the effects of 'overheating' – this is known as deflationary fiscal policy.

The reverse of this is used when an economy is experiencing the symptoms of recession – increasing government expenditure and decreasing taxes gives the economy a helping hand and is known as expansionary fiscal policy. In the 1970s political and economic attitudes changed to bring about an age of monetarism that went hand-in-hand with monetary policy becoming the focus for control. John Sloman (see bibliography) tells us that "the high point of monetarism came in the early 1980s. Governments around the world made the control of inflation the number one short-term macroeconomic objective".

Monetary policy is said to be very controversial as many politicians and economists are not agreed on its effectiveness or how it should be used. Currently it is hard to ascertain whether we are in a recession but it is clear that inflation is increasing and something must be done about this. John Sloman explains, for example, that if a government is to reduce the supply of money over the long-term then they will almost certainly have to seek to reduce the public sector borrowing requirements.

This must be done by either decreasing government expenditure or increasing taxes (or a combination of the two) which is deflationary and mirrors the fiscal approach. Another approach is to control borrowing, also known as credit rationing, to reduce aggregate demand without the need to raise interest rates but this comes with its own troubles as it quashes any competition between banks who will in turn become far more discriminatory towards borrowers.

Finally we come to the control of interest rates. Raising interest rates directly affects the demand for money by increasing the cost of borrowing – not good for those who already have high borrowing commitments and generally not a good move to make around the time of an election. Demand for loans, however, is inelastic and so interest rates would likely need a large increase to have the required effect. Raising interest rates also increases exchange rates which is bad news for exporters.

According to chapter 2 – maintaining macroeconomic stability – of the budget report this year taken from a government website (see appendix A) "the monetary policy framework is delivering low and stable inflation, while allowing the Bank of England's Monetary Policy Committee to respond to risks generated by weakness in the world economy; and the fiscal rules are delivering sound public finances and allowing the automatic stabilisers to operate freely to support monetary policy".

Although the MPC has been given autonomy over the control of interest rates it is still required to operate within the government's inflation target. The chancellor, it would seem, is rather confident concerning the issue of inflation and believes the UK to be "well placed" in the global picture.