How Monetary Policy Can Raise the Level of Aggregate Demand in the Short Run

Government can influence economic activity in two ways: monetary policy and fiscal policy. Fiscal policy affects the economy by changing the volume of government spending or taxes. Monetary policy is the regulation of the money supply, weight of gross of aggregate demand, which in turn influences the interest rate. There are two types of monetary policy: monetary expansion and monetary contraction. In the first case, the money supply is increased, in the second case on the contrary decreased. This essay reflects the ways the monetary expansion increases the money supply and it can also be seen how the rise in money supply affects the output. The present essay shows how Bank of England raises demand by such policy. The first part of essay shows the conventional ways of monetary policy and the second part reflects unconventional ways of influencing money supply. The significance of such policy will be proved by illustration of the monetary policy of Bank of England since 2009.

The first conventional method of monetary policy is open market operations. This means that Central Bank can affect the money supply by purchasing and selling bonds. When the Central Bank buys bonds, it puts money to the circulation. On the contrary when the Central Bank sells bonds, it takes money away. If the money supply becomes more this means that in equilibrium the LM curve will shift to the right which leads to a lower interest rate. If the interest rate is lower, then people are more willing to spend than to save, which in terms increase consumption, hence output will increase.

The other conventional monetary policy is reserve requirements. When the Central Bank increases bank reserve ratio, the banking sector’s excess reserves are decreased. This brings to a decrease to the supply of money. Consistently, a reduction in reserve requirements stimulates a rise in the supply of money. The more money in use, the higher is the production. It prevents banks from lending as much money as they want. But this method is not useful nowadays, because it is not so effective.

The third method of monetary policy is the discount rate. Discount rate is the interest rate the central bank charges from financial institutions when they borrow reserves from it. The lower the discount rate, the more money banks want to borrow. This also causes a lowering of interest rate for credit by banks. Consistently, the cost of credit is reduced, more people and firms will borrow money and the economy activity will rise which induces spending.

However, after the 2008 financial crisis it was revealed that there are other unconventional methods affecting the aggregate demand in the short run. The most obvious example is the monetary policy carried out by the Bank of England since 2009. This method is included Quantitative Easing, in other words printing more money. This policy was generated by the Monetary Policy Committee. The structure of this policy is that Bank of England buys assets by the electronically created new money and introduce it this into the economy. By this way Bank of England increases its assets and injects cash flow to economy.

The Bank buys assets from private sector. The most purchased assets are government bonds. This money introduction has different effects. When the Bank purchases assets, this increases their price, hence reduces their yield. So the return on these assets decreases. Consequently, the sellers of assets are stimulated to use money received from the bank by investing in other financial assets. Therefore, it heats up economic activity which means that aggregate demand increases.

Another advantage of the raised price of assets is that it makes some people’s lives better. This also leads to more spending on goods and services. In other words it increases demand.

The Bank of England also purchases corporate bonds. These purchases help companies to increase money which they can invest in their business.

By this unconventional monetary policy the Bank of England buys more assets from firms than from banks. The reason is that, if the Bank of England buys assets from commercial banks, these banks would use money to finance new loans. New loans induce more spending. However, this way is rather weak, because after 2008 crisis banks try to restore their finances. This support helps to raise the amount of money in circulation

Figure 1.1 Quantitative easing in the UK

Loans to APF are the loans the Bank of England made to the legal entity (the Asset Purchase Facility) in charge of buying assets from the market on behalf of the Bank

Source: Bank of England August 2012 Inflation Report

Moreover, for keeping interest rates stable, the Bank of England decides to give Bank Rate on money which is kept in reserve accounts. This Bank Rates was adjusted to 0,5%. Fin 2009 interest rate was cut up to 1% and after in 2012 Bank Rate decreased up to 0,5%. Banks set a monthly objective for reserve balances.

Short-term market interest rates are kept p to 1%in line with Bank Rate by paying Bank Rate on all cash held in the reserves accounts at the Bank. The asset purchase target is achieved by purchasing or, in the event that the target is reduced, selling assets through the Asset Purchase Facility.

Prior to March 2009, monetary policy was solely implemented by keeping short term market rates stable and in line with Bank Rate. This was achieved through a ‘reserves averaging’ regime. Under this system, banks set a monthly target for their reserves balances. The Bank used its Open Market Operations to supply the correct amount of reserves to meet the banks’ aggregated demand. Banks that maintained balances close, on average, to their target received interest on their balances at Bank Rate. But they were charged if their reserves balance was on average either excessively over or under their monthly target. A bank could avoid that charge by making use of the Operational Standing Facilities to meet their target.accounts

All above mentioned monetary policy tools help to augment aggregate demand. As it is clear from the monetary policy of Bank of England nowadays, unconventional ways of monetary policy are more useful and effective.