In the COVID-19 pandemic laden economy, the United Kingdom is struggling to control inflation, with levels reaching a 10 year high of 4.2% from an end year goal of 2%. The Bank Of England (BOE) are deciding on possibly implementing intervention to increase interest rates from 0.1% to 0.25% to counteract uncertainty in the rising inflation rates. Interest rates are defined as the rate at which central banks charge on top of money that has been borrowed in an economy towards banks. This is connected to the idea of inflation, which is the rate at which prices for goods and services rise within an economy, a concept often measured using the Consumer Price Index. A central concept of monetary policy revolves around the idea that with lower interest rates set by the central banks, consumers will have more money to spend on goods and services, therefore increasing inflation and spending. As the rate of interest within the economy is dependent on a rate set by the central bank, the central bank is therefore able to control inflation by increasing or decreasing the interest rate within an economy.
The key concept that this article relates to is that of intervention. The BOE is unsure of the feasibility of the market at its current state, meaning that the rising inflation could lead to detrimental effects on the status quo, a slowly recovering economy, and counteract policies aiming to recover from the pandemic. Therefore, the BOE led intervention proposed is a rise in the rate of interest for banks within the economy, which will counteract this rise in inflation. The BOE views this policy as one that can balance out the effects of a recovering economy with the need to maintain economic goals in an economy that sticks to specific inflationary targets in the future.
The economy of the UK is now at short run equilibrium (Q1,P1), with the equilibrium (Q2,P2) illustrating the equilibrium with a change in interest rates from the BOE. As decreasing interest rates leads to lower borrowing from the population, levels of consumption and investment decrease, which are determinants of Aggregate Demand in the short run, which is defined as the total goods and services within the economy at a certain period. Lower consumption and investment in the economy lead to a shift to the left in AD from AD1 to AD2, and a new equilibrium at (Q2,P2)
Several key steps are necessary to understand in order to evaluate the effectiveness of this policy. As well as lower interest rates leading to lower consumption and investment within the economy, leading to a lower level of AD, the expectations of the consumer in terms of inflation can lead to a shift in AD, as an expectation of inflation could lead to the concept of panic buying in an economy, which would shift AD to the right.
While incorporating an increase in interest rates within the UK will lead to a reduction in aggregate demand in the short term, the dangers of a rising inflationary gap have severe consequences on the way in which consumption and investment occurs in the country. A level of inflation that severely oversteps the expectations of the central bank can lead to uncertainty of the consumers, as a rising inflation rate consequently leads to a decrease in the value of savings of the consumers, and as well as this, lower real wages.
The short run Phillips Curve shown in the figure above connects rising inflation and unemployment within the economy, and views there to be a negative relationship between the two concepts; a rising rate of inflation leads to a decrease in unemployment within an economy. In this case, the reduction in inflation from the increasing rate of interest would shift the equilibrium to the right from (4.2,U1) to (2,U2). Monetary policy aiming to decrease inflation could rebound levels of unemployment back to those before the rise in inflation, an undesirable option for the BOE, and therefore decrease employment within the economy. As well as this, the uncertainty regarding levels of inflation and deflation mean that a policy aimed at reducing inflation could lead to further deflation beyond levels desired by the central bank and regulators, therefore leading to an economic crisis with high deflation within the economy.
In conclusion, in order to best address the issue of a rising rate of inflation within the economy, the BOE needs to determine the root of the rising inflation, and therefore make the decision if a rise in interest rates is necessary. Considering the pros and cons of both sides of the topic, a rising inflation rate, and decreasing the rate of inflation, the monetary policy that the BOE pursues must take into account both sides of the argument.
Works Cited
Partington, Richard. "Bank Of England under pressure to increase interest rates after inflation rise". The Guardian, 2021, https://www.theguardian.com/business/2021/nov/17/uk-inflation-jumps-to-highest-level-in-10-years-as-energy-bills-soar. Accessed 15 Nov 2021.