HOW MONETARY POLICY WORKS
We need to examine how the Bank uses monetary policy, not just to set interest rates but by intervening in the money market on a daily basis to ensure that the rate it has set becomes the equilibrium rate. This then has the longer-term effect on a range of variables, thus the Bank is able to meet its inflation target.
Source '' The Bank of England
The Bank sets a rate of interest at which it lends to banks, this affects the rates at which the banks, building societies and other financial institutions set for their own lenders and indeed savers. When the Bank alters the interest rate it is attempting to influence the level of spending in the economy. The ...view middle of the document...
Financial assets, shares and bonds are also affected by a reduction in interest rates. Some share prices will increase, for example a company with high level of borrowing will save money, make more profit and possibly pay higher dividends. Share prices of companies selling consumer goods may well increase because investors anticipate that consumers with more money will increase demand.
The housing market is likely to be stimulated by lower interest rates. First time buyers find it easier to borrow, homeowners moving up the ladder can afford bigger mortgages, demand for houses increases and prices rise. Even if people don’t move house, they can borrow more by remortgaging because the house has a higher valuation. The extra borrowing is likely to be spent on consumer goods.
If homeowners don’t move house or remortgage they are still likely to spend more money '' simply because of the feel good factor due to rising house prices. In addition they are also less likely invest in any other form of saving as they anticipate that house prices will continue to rise.
It is difficult to predict the how exchange rates will be affected by a reduction in interest rates. If UK rates change unexpectedly and not in line with other countries, UK investment becomes less attractive to overseas investors, resulting in an outflow of money from the UK. Sterling weakens, making the cost of imports higher and reducing demand. The price of exports will decrease and stimulate demand from abroad. However, Weale et al (1989) cautions, that when interpreting movements in exchange rates one must understand that there are two kinds of irrationalities at work; firstly, changes in sentiment tend to be infectious and secondly,...