The Bank of England (BoE) finds itself at a crossroads in terms of its record low interest rate that stands as an attempt to spur Aggregate Demand (AD), The overall demand for all products in an economy at any given price level, in spite of an inflation rate of 2.7% that is above the target rate of 2%. BoE recognizes that in a period of extended economic contraction it is important to spur AD as any decrease in AD results in a loss of real output (RGDP). BoE only has the ability to do this using monetary policy and adjusting the interest rate to incentivize people to spend. A low interest rate makes it borrowed money more accessible and increases AD. On the other hand, BoE’s low interest rate will not do anything to mitigate inflation and bring it back to the target rate of 2%. BoE has prioritized increasing their potential output (Yeq1 -> Yeq2) to pull them out of a stubbornly unshakable recession over reaching their target rate of inflation. BoE’s strategy is shown in the graph below.
BoE has chosen the strategy of preserving and attempting to raise aggregate demand for two reasons; the first being that current inflation in the UK is cost push inflation, and the second being the ongoing policies of austerity. Cost-push inflation, as outlined in the diagram below, is a result of high commodity prices, specifically oil. Oil is a very prolific factor of production and an increase in its price has wide reaching effects on the costs of production in many industries. An increase in the costs of production will result in a decreased Aggregate Supply (AS), the total number of goods and services that firms are willing to provide at every price level. A decrease in AS will always lead to a decrease in real output and an increase in the price level, the opposite of what any economy wants. The cost-push inflation and its effects are shown in the graph below.
Westminster could attempt to mitigate the high costs of production by subsidizing oil production and...
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