Bank of England’s contractionary policy and UK economy
This Macroeconomics IB Internal Assessment, formatted in APA style, explores the effectiveness of contractionary monetary policies by examining the Bank of England’s decision to cut interest rates from a 16-year high. The IB assessment example discusses the impact of this policy on inflation and economic well-being, using the key concept of economic well-being to analyze the broader implications for the UK economy. The analysis is based on an article from Reuters, providing a comprehensive examination of the factors leading to the rate cut and its expected effects on various economic sectors.
November 2, 2024
* The sample essays are for browsing purposes only and are not to be submitted as original work to avoid issues with plagiarism.
Title of the Article
Bank of England cuts interest rates to 5% in first reduction
since March 2020
Source of the Article
Reuters
https://www.reuters.com/markets/rates-bonds/bank-england-cut
s-rates-16-year-high-careful-future-moves-2024-08-01/
Date of the Article
August 1, 2024
Date of Commentary
28th August 2024
Word Count
776
Unit of the syllabus that
relates to the article
Macroeconomics
Key Concept
Economic well-being
Bank of England cuts rates from 16-year high, 'careful' on future moves
By Reuters
August 1, 20246:26 AM CDTUpdated 3 months ago
A view of the Bank of England building, in London, Britain, July 3, 2024. REUTERS/Maja
Smiejkowska/File Photo Purchase Licensing Rights opens new tab
By David Milliken, Andy Bruce, and Suban Abdulla
LONDON, Aug 1 (Reuters) - The Bank of England cut interest rates from a 16-year high
on Thursday after a narrow vote in favor of policymakers divided over whether inflation
pressures had eased sufficiently.
Governor Andrew Bailey - who led the 5-4 decision to lower rates by a quarter-point to 5%
- said the BoE's Monetary Policy Committee would move cautiously going forward.
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"We need to make sure inflation stays low, and be careful not to cut interest rates too
quickly or by too much," he said in a statement alongside the decision.
Thursday's decision was in line with the forecast in a Reuters poll of economists but
financial markets had only seen just over a 60% chance of a cut.
Rates have been on hold for almost a full year - the longest period rates have been left
unchanged at the peak of a BoE tightening cycle since 2001 - and this is the first cut in rates
since March 2020, at the start of the COVID-19 pandemic.
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In June, the BoE voted 7-2 to keep rates on hold, and minutes of the most recent meeting
showed the decision to cut rates had been "finely balanced" for some members - echoing
the language used previously when rates were kept unchanged.
None of the policymakers who changed their vote at this meeting - Governor Andrew
Bailey and Deputy Governors Sarah Breeden and Clare Lombardelli - had spoken publicly
about monetary policy since the BoE's last meeting in June.
Speaking opportunities had been limited by an election campaign that ended on July 4,
which brought the Labour Party to power with a large majority.
The BoE said policymakers had been briefed on the government's public sector pay and
fiscal policy announcements this week, but their impact would only be incorporated into
the BoE's forecasts after the Oct. 30 budget.
British consumer price inflation returned to the BoE's 2% target in May and stayed there
in June, down from a 41-year high of 11.1% struck in October 2022.
This leaves British inflation lower than in the eurozone - where the European Central Bank
cut rates in June - and the United States, where on Wednesday, the Federal Reserve kept
interest rates steady but opened the door to a September cut.
INFLATION TO RISE
However, the BoE expects headline inflation to rise to 2.75% in the final quarter of the year
as the effect of last year's steep falls in energy prices fades before returning to its 2% target
in early 2026 and later sinking below.
The long-time lags for interest rates to affect inflation mean the BoE is more focused on
what it sees as medium-term drivers of inflation: services prices, wage growth, and more
general tightness in the labor market.
Services inflation came in well above the BoE's forecasts in June, but the BoE put this
down to "volatile components" and regulated prices that were influenced by high headline
CPI earlier in the year.
Wage growth at nearly 6% is almost double the rate the BoE views as consistent with 2%
inflation but is slowing in line with the central bank's expectations.
The BoE now thinks Britain's economy will expand by around 1.25% this year, revised up
from its previous forecast of 0.5%, reflecting stronger-than-expected growth during the
first half of this year.
Unemployment will rise slightly as high interest rates continue to bear down on growth, the
forecasts showed, reducing upward pressure on inflation.
However, the BoE acknowledged the risk that inflation pressures might prove more
persistent and keep inflation above target for longer than its main forecast.
Before the meeting, financial markets priced in two quarter-point cuts by the BoE this year.
The BoE forecasts were based on market expectations, which show interest rates falling to
about 3.7% by the end of 2026.
Next month, the BoE will also need to decide whether it will continue the 100 billion pound
a year reduction in its bond holdings built up between 2009 and 2020.
In its report on Thursday, the BoE stuck with its assessment that these sales had a limited
impact on the gilt market and that the high level of interest rates gave it scope to fine-tune
monetary conditions if the impact proved greater in the future.
The BoE estimated that its bond sales had contributed 0.1-0.2 percentage points to a 2.75
percentage point rise in 10-year gilt yields between February 2022 and June 2024.
Commentary
The article discusses the decision by the Bank of England to cut interest rates from a 16-year
high. This decision was made after a narrow vote by policymakers (5-4) as they were divided
over whether inflation pressure had eased sufficiently. The interest rate was reduced by a quarter
point to attain 5%. The decision to cut interest rates is a contractionary monetary policy aimed at
inflationary pressure that resulted from expansionary policies that were implemented after the
coronavirus pandemic. The measure has been taken to ease inflation from a 41-year high of
11.1% that struck in October 2022. The key concept discussed in this commentary is economic
well-being. The Bank of England is focusing on protecting the country's economic well-being.
The Bank of England has been fighting inflation using expansionary monetary policy, and the
policies have been successful.
Figure 1: Inflation in the UK Economy
Figure 1 is an illustration of the UK economy after the government used expansionary monetary
and fiscal policy after the effects of the COVID-19 pandemic. The world economy was affected
and the policies used led to a rise in inflation. The UK government used policies that led to
growth in aggregate demand from AD to AD1. The overall price of goods and services in the
economy increased from P1 to P2. The UK economy grew from Y1 to Y2. These policies led to
an increase in inflation to 11.1% in October 2022. Since then, the UK government has been
focusing on curbing the growth of inflation and increasing interest rates with the aim of
increasing the cost of borrowing. Consequently, the flow of money was reduced, and the level of
inflation started falling significantly. Although the MPC was split by five votes to four, it is
evident that many of the members are aware that higher interest rates had serious impacts on
economic growth. By cutting the interest rates, the central bank tries to reduce the cost of
borrowing, hence stimulating investment and consumption. This may result in the fueling of
economic activities and employment and may also smoothen the deleterious impact of economic
downturns. This move reflects a proactive response to the impending economic challenges and
securing financial stability.
Figure 2: The effects of hiking interest rates
Figure 2 illustrates the current state of the UK economy and what warrants the reduction
of interest rates. Higher interest rates lead to increased borrowing costs, which discourages
borrowing for both individuals and firms in the private sector. Economic growth reduces from
Y2 to Y1 because the aggregate demand falls from AD1 to AD2. Prices reduced from P2 to P1.
Consequently, lower economic growth may cause a recession. The UK government's intervention
by cutting the interest rate to 5% will reverse this reaction in the economy.
This policy will benefit the consumers who are individual borrowers. This is because they
will borrow more for consumption. Besides, businesses will borrow more and invest, creating job
opportunities in the UK economy. The multiplier effect will help multiply wealth in the UK,
leading to improved standards of living for residents. The aggregate demand will increase, as
illustrated in Figure 1, and hence, the economy will be expected to expand significantly.
Consumers and mortgage owners will benefit from this policy because they will pay less and,
hence, retain more income. Lower interest rates will promote spending and investment because
there will be no benefit in saving.
Although this policy will effectively bring greater economic well-being, there are many
limitations and risks involved with such interventions. While low interest rates are appealing in
the short run, they have unavoidable consequences in terms of asset bubbles, increasing
household debts, and reduced incentive to work for fiscal prudence. Admittedly, this policy
might be limited beyond the Bank of England by exogenous factors such as disruption in global
supply chains or emerging geopolitical tensions. In the long term, the intervention may lead to
insight into the very problem of inflation, and therefore, there is a need to balance it with other
policies that balance out the effect.
The recent cut in the interest rate by the Bank of England underlines how crucial
government intervention is in managing continuous economic challenges and maintaining
economic well-being. While such actions are essential to keep instability at bay and grow
economies and businesses, they have to be finely calibrated, keeping short-term imperatives in
mind with long-term sustainability. Navigating such intricacies of an advanced global economy,
the interplay between state interventionism and market forces shall thrive.
November 2, 2024
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Academic level:
IB Student
Type of paper:
IB Internal Assessment
Discipline:
Economics
Citation:
APA
Pages:
3 (776 words)
Spacing:
Double
* The sample essays are for browsing purposes only and are not to be submitted as original work to avoid issues with plagiarism.
