Introduction
The need for government and central bank intervention in the market has historically received support from a number of scholars. For instance, the economic idea of government intervention (demand-side management) in the market is largely attributed to the Keynesian economics, which is highlighted in the book, “General Theory of Employment, Interest, and Money” by John Maynard Keynes published in 1936. According to the Keynesian economics, automatic market forces (alone) may not trigger a condition of economic equilibrium, particularly during a financial crisis. This is primarily due to the presence of economic inefficiency brought about by market externalities. Closely linked to government intervention is the intervention of monetary authorities, the central bank, in the economy. Monetary authorities primarily intervene through monetary policies, as complement (or alternative) to fiscal policies implemented by the government. Although both fiscal and monetary policies are geared towards the achievement of similar macroeconomic goals, their applicability tends to differ significantly. Ideally, this paper tends to be biased towards the analysis of the effectiveness (positive and negative aspects) of a monetary policy in a financial crisis.
Monetary policy of the Bank of England
Fernando (2011) defines monetary policy as a discretionary action taken by monetary authorities (central bank) aimed at influencing money supply, availability of money and interest rare in order to achieve some set objectives such as full employment, economic growth, price stability, exchange stability and minimization of economic inequality. Arestis et al. (2006) postulates that the UK monetary policy is under the direct influence of the Monetary Policy Committee (MPC), which consists of officials from the Bank of England.
Fundamentally, UK monetary policy is based on inflation targeting; keeping an inflation (CPI) target of 2% +/-1 (see figure 1). The inflation target set by the MPC of the Bank of England is relatively similar to that of the Reserve Bank of Australia (RBA) and Federal Reserve Bank of U.S. The RBA’s monetary policy aims to achieve the inflation target of 2-3%. Moreover, the inflation target of Federal Reserve Bank is pegged at a rate of 2%. The MPC of the Bank of England is autonomous or indepenent in setting interest rates aimed at achieving the targeted inflation rate.
Figure 1: Inflation targeting in UK
In order to achieve the desired monetary policy goals in UK, the monetary policy implementation by the MPC is based on a number of monetary instruments (tools). However, the commonly applied tool is the ‘base rate’, which is the interest rate charged on borrowing made by commercial banks from the Bank of England. This rate is lowered (or increased) in order to raise (or reduce) the level of CPI (Fuhrer and Sniderman 2000). Bank of England’s monetary policy decisions during a financial crisis
There is no generally agreed definition of a financial crisis. However, some sources define a financial crisis as situation where by an economy’s money supply is overwhelmed by the demand for money (Howells and Bain 2009). Different sources defined a financial crisis as loss of confidence in an economy’s financial systems causing depositors (investors) to withdraw their funds. Also referred to as an economic crisis, a financial crisis is usually characterized by low levels of aggregate demand (AD), high levels of unemployment, low investments, and low prices.
Generally, it can be argued that monetary policy is a very valuable alternative to fiscal policies in regulating economic variables in an attempt to stabilize the economy (Bindseil 2004). In achieving economic and price stability, central banks tend to employ an active monetary policy, which is aimed influencing the level of aggregate demand in an economy.
In order to understand how monetary policy works, let’s consider an example of a situation where the Bank of England is targeting an inflation rate of 5% in this year. If the current inflation rate seems to be lower than the inflation target, for instance 2 %, the central bank will be compelled to employ an expansionary monetary policy. This policy is essentially applied to in order to increase the monetary base or the size of money supply in an economy, and consequently boost AD. It is application; monetary policy has no directly influence on the level of AD or inflation. Economists argue that monetary policy can only affect inflation through a monetary policy transmission process (Mishkin 2010; Bordo and Filardo 2005). In order to illustrate this concept, let’s focus on our previous example. In this case, if the desired level of inflation (inflation target) is to be achieved, the central bank will apply one of its monetary policy tools. For instance, the bank may decide to lower its base lending rate or buy its T-bills through active participation in the open market operations (OMO). Either of these measures, if effectively applied, will increase the amount of money supply in an economy. Owing to economic theory of money markets, a change (an increase in this case) in money supply will cause a disturbance in the money market equilibrium as illustrated in figure 2.
Figure 2: Shift in LM-curve due to Money market disturbance
The initial equilibrium (e0) in the money market and product market is achieved at a point of intersection of LM0 and IS resulting to an equilibrium interest rate and income of r0 and Y0 respectively. However, if e0 is coupled with an inflation rate below the inflation target, a decline in the central base lending rate will increase money supply making the LM-curve to shift from LM0 to LM1, and consequently reduce interest rates from r0 to r1. Given that there is an inverse relationship between interest rates and investment, such a decrease interest rate from r0 to r1 will increase income from Y0 to Y1. National income will increase since investment is a positive function of AD. Given a constant IS-curve, the new equilibrium will settle at point e1.
In order to further highlight how the monetary policy transmission process affects inflation, it is crucial to examine the AD-AS model (figure 3). Basing our argument using the AD-AS model, illustrated in figure 3, it can be argued that an increase in AD will put an upward pressure in price levels (CPI), as AD exceeds AS, resulting to an increase in the rate of inflation from 2% to 5%, which is the inflation rate target.
Figure 3: AD-AS model
In general, monetary policy works successful well in an economy characterized by extremely high interest rates, and perfectly inelastic speculative demand for money. Expecting interest rate to fall in the near future, individuals tend to hold all the wealth in bonds. Based on the three ranges of the LM-framework, it can be argued that monetary policy works well in classical range where interest elasticity is zero.
Guati (2008) asserts that the application of monetary policy is less successful during a financial crisis primarily due to liquidity trap. At very low interest rates (interest rates are perfectly elastic); individuals tend to hold all their wealth in cash. This implies that an increase in money supply, for instance, will not stimulate AD by lowering interest rates. Rather, it will extend the liquidity trap (Modigliani 1944). The above situation implies that the independency of the monetary policy of the Bank of England during financial crisis may be more problematic than beneficial. Therefore, during a financial crisis, the government needs to interfere in the policies made by the bank’s MPC, and maybe recommend for a monetary policy mix.
Conclusion and Recommendation
The application of an expansionary fiscal policy can be said to be a vital substitute for monetary policy during a financial crisis (Keynesian range) when interest rates are perfectly elastic (Michael 2004; Romer 2000). The rationale for apply this policy is based on the fact that AD stimulation by fiscal policies does not depend on changes in interest rates (see figure 4). In the figure, an expansionary monetary policy such as an increase government expenditure will shift the IS function from IS0 to IS1, making income to increase from Y0 to Y1 at constant interest rate.
Figure 4: Applying fiscal policy in a financial crisis
Reference List
Arestis, P., McCombie, J. S. and Baddeley, M., 2006. The new monetary policy: Implications and relevance. Cheltenham, England: Edward Elgar.
Bindseil, U., 2004. Monetary Policy Implementation: Theory--past--present. Oxford: Oxford University Press.
Bordo, M., and Filardo, A., 2005. Deflation and Monetary Policy in a Historical Perspective: Remembering the Past or Being Condemned to Repeat It? Economic Policy 44 (20), p. 799–844.
Fernando, A C., 2011. Business Environment. New Delhi: Pearson.
Fuhrer, J., and Sniderman, M., 2000. Monetary Policy in a Low-Inflation Environment: Conference Summary. Journal of Money, Credit, and Banking 32 (4), p. 845–69.
Gauti B., 2008. “liquidity trap”. The New Palgrave Dictionary of Economics, 2 (5), p. 154-60.
Guati, B. et al., 2004. “Policy Options in a Liquidity Trap”. American Economic Review, 94 (2), p. 76-79.
Howells, P. G. and Bain, K., 2008. The economics of money, banking and finance: A European text. Harlow, England: Prentice Hall Financial Times.
Mishkin, F. S. (2013). The economics of money, banking, and financial markets. Boston: Pearson.
Modigliani, F., 1944. Liquidity Preference and the Theory of Interest and Money. Econometrica 12 (1), p. 45-88.
Romer, D., 2000. Keynesian Economics without the LM Curve. Journal of Economic Perspectives, 14 (2), p. 149-69.
