Headline Haydenomics : How does an expansionary monetary policy impact the individual components of Aggregate Demand and therefore the rate of inflation in the UK?

In 1998 the Monetary Policy Committee (MPC) was set up to set interest rates in the UK. This was given as a job to the MPC as governments were abusing the power, changing the interest rates to make it seem like the economy was doing well and therefore having more of a chance to win elections. When the interest rates are decreased this is known as expansionary monetary policy and will more than likely have a positive effect on Aggregate Demand (AD). Aggregate Demand is defined as total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It is represented by the aggregate-demand curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide [1].This is usually is usually shown with a graph that is showing the comparison between the Real National Output (RNO) and General Price Level (GPL) within a market.

AD is made up of five different components and they are; investment expenditure (I), consumption expenditure (C), government spending (G), exports (X) and imports (M). I will be showing in this report how a decrease in interest rates (which is known as expansionary monetary policy) will affect the overall positioning on the curve AD. Ad is calculated by the equation AD=C+I+G+(X-M).

Consumption Expenditure (C)

61% of Aggregate demand is made up of the component C [2] which refers to the purchase of goods and services for households. As the interest rates have lowered within this hypothetical economy, household’s marginal propensity to consume is increases. This means that people will spend more money rather than save it due to the fact that the interest rates of the banks are lower and households will therefore get less interest and money by putting their money into the banks. Due to the fact that people are spending more and C is a positive component of AD, this causes a shift to the right of the curve as shown in Fig 1. The increase in AD therefore leads to an increase in the GPL and RNO. The increase in RNO can be seen as a decrease in unemployment and there increase in the GPL shows inflation. C is such a large component of AD that even only the slightest increase on C can cause a huge shift towards the right.

Investment Expenditure (I)

When the interest rates are lowered by the MPC it is less attractive for investors to leave their money in a UK bank so their money is taken out of the banks and put towards firms. I will cover the impact of the money being taken out later but this means the investors have got more of a chance of making money by putting it into firms. Because I is a positive component of AD it therefore shifts to the right as shown in Fig 1. The investment expenditure has increased as has employment and economic activity as you can see by the shift from Y1 to Y2 in Fig 1. This therefore causes inflation because AD has shifted to the right and there has been an expansion along Aggregate Supply.

Government Spending (G)

The expenditure that the government use is known as government spending. This is how much money the government are putting into firms and the economy in general. When interest rates are lowered by the MPC the treasury borrow more money as it is cheaper to at that time. Especially if the base rate which the Bank of England are as low as what they are using currently which is 0.5% [3] it encourages them to take money out and try and invest to get the economy going. AS there is more investment the economic activity of the country increases. This is again shown in Fig 1 by the shift from Y1 to Y2 and also the way that as G is a positive component of the equation AD increases and is shown by the shift to the right of the demand curve. There is also a drop in unemployment as shown by the shift.

Exports (X) and Imports (M)

When the MPC have employed an expansionary monetary policy the interest rates have therefore lowered. As I stated when talking about Investment Expenditure this defers anyone from having money into the UK Banks as they won’t get as much money from the interest rates. They therefore take their money out of the banks and make the pound less desirable. With a Weak Pound, Imports Dearer, Exports Cheaper (WPIDEC) the amount that we import and export changes. Other countries are able to get more product from the UK for a cheaper price due to the fact that the pound is much weaker. This is why Exports are cheaper and X rises causing the AD curve to again shift to the right (as shown in Fig 1) because X is a positive component. There is an opposite affect with imports due to the fact that the pound can get less for its value abroad. Imports then decrease and more is produced within the UK itself. But as M is a negative component of the equation (X-M) this again causes a shift rightward of the AD curve. All of this causes Inflation to rise.

Conclusion

The current UK Inflation rate is extremely low at 0.2% [4] where the government aim is to keep it at 2%. I have shown in this report how a good way to get the inflation rate higher is the expansionary monetary policy where they are able to lower interest rates to increase economic activity. As the base interest rate is already so low it is almost impossible to lower it anymore. Fiscal policy is another option that must be used in response to the fact that it’d be difficult to use monetary policy with the current state of the Economy. The forecast for the year ahead [5] is that inflation will rise to about 0.25% and stay there for most of the year due to fluctuating oil prices which can affect the rate of inflation massively.

The ability that AD has to change inflation is due to each individual component of Aggregate Demand and if one of them changes, ceteris parabus, the curve will shift to either the left or right. When interest rates fall AD will almost always shift to the right increasing economic activity, reducing unemployment and overall rising the interest rate.

References

[1] Aggregate Demand

http://www.investopedia.com/terms/a/aggregatedemand.asp, Accessed 4^th February 2016

[2] Myers, M, Wales, P, Taylor, C, Luff, M, Chirambo, A, Brown, T.

Economic Review, February 2016.

Page 26 - Office for National Statistics

[3] UK Interest Rates held at 0.5% after 8-1 bank vote

http://www.bbc.co.uk/news/business-34473146 Accessed 8^th February 2016

[4] United Kingdom Inflation Rate

http://www.tradingeconomics.com/united-kingdom/inflation-cpi Accessed 11^th February

[5] United Kingdom Inflation Rate

http://ieconomics.com/uk-inflation-rate-forecast Accessed 11^th February