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Home > Monetary Policy > How does monetary policy work?

How does monetary policy work?

When the Bank of England’s Monetary Policy Committee (MPC) changes its official interest rate – known as Bank Rate, it is attempting to influence the overall level of activity in the economy in order to keep the demand for, and supply of, goods and services roughly in balance. Doing so results in a rate of inflation in the economy consistent with the Bank’s 2% inflation target.

When demand for goods and services in the economy exceeds supply, inflation tends to rise above the Bank’s target rate of 2%. On the other hand, when supply exceeds demand, inflation tends to fall below the Bank’s 2% target.

By changing Bank Rate – the rate of interest that the Bank of England pays on reserve balances held by commercial banks and building societies – the Bank of England is able to influence a range of other borrowing and lending rates set by commercial banks and building societies, and hence spending in the economy, in order to keep inflation on track to meet the 2% inflation target. A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can also affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased.

Changes in Bank Rate also affect the price of financial assets and the exchange rate, which affect consumer and business demand in a variety of ways.

For example, lower interest rates can boost the prices of assets such as shares and houses. Higher house prices enable existing home owners to extend their mortgages in order to finance higher consumption. Higher share prices raise households’ wealth and can increase their willingness to spend.

With respect to the exchange rate, a rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents, tending to make sterling assets more attractive. That should raise the value of sterling, reducing the price of imports and increasing the price of UK exports. This reduces demand for UK goods and services abroad. However, the impact of interest rates on the exchange rate is, unfortunately, seldom that predictable.

Changes in spending feed through into output and, in turn, into employment. That can affect wage costs by changing the relative balance of demand and supply for workers. But it also influences wage bargainers’ expectations of inflation – an important consideration for the eventual settlement. The impact on output and wages feeds through to producers’ costs and prices, and eventually consumer prices.

There are time lags before changes in interest rates affect spending and saving decisions, and longer still before they affect consumer prices. While it is difficult to be too precise about the size or timing of all these channels, the maximum effect of a change in interest rates on output is estimated to take up to about one year, and the maximum impact on consumer price inflation takes up to about two years. So interest rates have to be set based on judgments about what inflation might be – the outlook over the coming few years – not what it is today.

While there is no practical upper limit to the level of Bank Rate, there is a level below which it cannot be reduced – known as the effective lower bound (ELB). In those circumstances, the committee can elect to undertake unconventional forms of monetary policy such as quantitative easing (QE), in order to provide further stimulus to the economy.

Quantitative easing is where a central bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target.

Key Resources

Inflation and the value of your money
A postcard from the Bank of England
Interest rates and the Monetary Policy Committee (MPC)
A postcard from the Bank of England
Quantitative easing (QE) – injecting money into the economy
A postcard from the Bank of England
Forward guidance
A postcard from the Bank of England