Monetary Policy involves changes in the base rate of interest to influence the rate of growth of aggregate demand, the money supply and ultimately price inflation.
Monetarist economists believe that monetary policy is a more powerful weapon than fiscal policy in controlling inflation. Monetary policy also involves changes in the value of the exchange rate since fluctuations in the currency also impact on macroeconomic activity (incomes, output and prices)
Changes in short term interest rates affect the spending and savings behaviour of households and businesses over time and therefore feed through the circular flow of income and spending. The transmission mechanism of monetary policy works with variable time lags depending on the interest elasticity of demand for different goods and services – e.g. the demand for interest-sensitive consumer goods and services bought on credit or the demand for capital investment from private sector businesses. Because of the time lags involved in setting an appropriate level of short-term interest rates, the Bank of England sets nominal interest rates on the basis of hitting the inflation target over a two year forecasting horizon.
Monetary Policy in the UK
Quote: Mervyn King on Monetary Policy’s Role in Britain
"What is the mechanism by which monetary policy contributes to a more stable economy? I would argue that monetary policy is now more systematic and predictable than before. Inflation expectations are anchored to the 2.5% target. Businesses and families expect that monetary policy will react to offset shocks that are likely to drive inflation away from target. In the jargon of economists, the “policy reaction function” of the Bank of England is more stable and predictable than was the case before inflation targeting, and easier to understand.4 More simply, monetary policy is not adding to the volatility of the economy in a way that it did in earlier decades"
Adapted from “The...