Economy

Stabilizing the Economy in the Backdrop of Chaos – Lessons from the UK

“Printing more money… leads to inflation”. This principle, the understanding of which is second nature to any economist, reveals the strong positive correlation between money supply and inflation. The basis of this phenomenon lies in the quantity theory of money. It exhibits a simple yet effective tool in economic policymaking, specifically with regard to inflation stabilization. Across multiple case studies of observed data, the most important cause of inflation has been reported to be the rate of money growth, something that is linked directly to monetary policy.

The UK places significant weightage on inflation targeting as part of its monetary framework. Currently, the target is 2 per cent, with the inflation rate standing at 1.7 per cent as of September 2019. Inflation is a key factor that the Bank of England considers when setting its base rate. If it pre-empts that the inflation rate is likely to fall below 2 per cent, it tries to increase consumer spending by cutting interest rates, thereby lowering the cost of borrowing. In this context, it becomes important to look at this very link between the central bank money supply measures, money supply and its impact on inflation, with a special focus on the United Kingdom.

The Monetary Policy Committee in the UK is a very active institution which monitors and corrects inflation rates to ensure that it stays within 1% to 2%. Additionally, the economic functioning is regulated by the government as well. When the rate deters from the expected rate, a letter is sent to the Chancellor intimating the authorities on the situation and the way forward to correcting this. For most part, the UK has enjoyed fairly stable interest rates, barring macroeconomic tremors owing to Brexit. It must be noted that there is an economic basis behind UK’s policy of inflation targeting, something that the United Kingdom has always used to correct inflation rate fluctuations.

How is Money Supply Measured?

Money supply — the total circulation of money in an economy —  is a key monetary  tool used by most central banks of different countries. Here, it is important to note that money is not limited to cash alone. Several tangible and intangible assets exist and perform the functions of money. Each country defines its own way of determining the money supply circulating in the economy.

In the UK, M4 is the broad monetary aggregate used by the Bank of England to depict money supply. It comprises of the M4 private sectors, which are UK’s private sector holdings. These include the UK’s currency in circulation i.e. pound sterling notes and coins, other sterling deposits, which include certificates of deposit, commercial papers, bonds and FRNs.

Inflation Targeting Leads to Fluctuations in Projected Money Supply?

A closer look of the money supply trend in the United Kingdom from 2015 to 2019 reveals the key motivations of the government in how it dealt with its inflation targets. The money supply trend appears to be closely linked with the government’s inflation targets. Whether the government achieved its inflation targets remains secondary, but what can be observed is the large number of fluctuations in this money supply trend. The reason? Bank of England’s attempt to maintain its 2% target.

So far we have established that the United Kingdom relies heavily on inflation targeting. It is thus clear that this fluctuation can be attributed to the Bank of England’s efforts to maintain its 2 per cent target despite other economic fluctuations. During Brexit years 2016-17, the Bank of England assumed a lower money supply, signalling that the United Kingdom’s monetary authority was making conscious efforts to retain a low inflation rate to avoid further fluctuations and in turn, protect the consumers. In the years post this, however, the money supply growth did pick up but inflation was also revealed to be high. This could perhaps be attributed to the effort made to boost consumer demand by increasing nominal wages through inflation.

Inflationary Impact

The Bank of England’s role is to set interest rates to influence the amount of consumer spending in the economy in order to ensure that inflation returns to its 2 per cent target conscientiously. The target is set low and is intended to stay stable to support economic growth and employment. Previously, in an attempt to recover from the global financial crisis, UK’s economy urged interest rates to stay extremely low to deter drastic fluctuations in other economic variables. Eventually, however, as the economy progressed towards growth more rapidly, with an inflation rate standing above the 2 per cent target, it sought little support from interest rate cuts.

In the past two years, the price levels in the United Kingdom have been going up by far more than the 2 per cent target on average. This can be attributed mainly to the depreciation in the Pound Sterling following the Brexit Referendum vote. The lowered pound has translated to higher costs for businesses purchasing raw materials from other countries. The higher cost of production is furthermore being transferred to consumers, eventually leading to a dip consumer demand. The rising prices of oil could also be held responsible for this trend. Therefore, although the Bank of England has played an active role with their inflation targets, other factors, apart from money supply, have also had a key role to play in affecting the rate of inflation.

In order to better the situation, the Bank of England decided to raise the official interest rate from 0.25 per cent to 0.5 per cent in November 2017 and then from 0.5 per cent to 0.75 per cent in August 2018. Since then, uncertainties over Brexit have risen, the United Kingdom’s economic growth has slowed down, and inflation rates have fallen back closer to their initial 2 per cent target. These interest rates are, in fact, likely to remain even lower now than before the financial crisis. In case of a smooth Brexit, households and businesses will have time to adjust to the new relationship between the United Kingdom and the European Union. This is only possible if the Bank of England takes a stronger stance on controlling any economic fluctuations.

“Printing more money… leads to inflation”

The central monetary authority of the United Kingdom relies on this principle heavily to affect the economic changes it desires. With the United Kingdom’s specific obsession with inflation targeting, this is all the more apparent in its policymaking. But as we can observe from the case of UK, there’s only so far that monetary expansion and contract policies can work; other macroeconomic factors play a significant role in affecting the inflation rates of an economy as well.

Picture Credits: Forbes.com



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