The Implications of UK Monetary Policy (1990-2012)


Term Paper, 2013
22 Pages, Grade: 90

Excerpt

TABLE OF CONTENTS

Abstract

Introduction

Literature Review

Transmission Mechanism

Data Source and Description

Modeling

Vector Autoregression (VAR)
Impulse Response Function (IRF)
Lagrange Multiplier Test for Autocorrelations
Joint Significance Test of the VAR Coefficients
Granger Causality

Regression Results

Concluding Remarks

Reference List

Appendix

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Abstract

Bank of England (BoE), as an independent organization stimulates the economic growth, by maintaining the transparency of the monetary policies conducted and regulates financial and foreign markets. In this report, I studied the relativity of monetary policy led by the central bank to the economic growth achieved during 1990-2011 in the UK and the effectiveness of the transmission mechanism through the channels involved. I concluded that it [monetary policy] had a direct impact on price stability using the intermediate targets such as monetary aggregates and official rates and, thereby influenced on the short term money market rates, firm and individuals’ saving behaviors and total unemployment level in the specified periods. Further, I ran a vector autoregression (VAR) function over annual gross domestic product and broad money (M3) within the time range specified and found three-lagged-order optimal for the applied model. The 3 year long recession in the early phase of 1990, the dismissal of the UK from Exchange Rate Mechanism (ERM) (1992-7), the invasions into Afghanistan (2001) and Iraq (2003), the first appearance of credit crunch (2008-9) were reflected in impulse response function (IRF). Also, Granger causality test resulted in money as being an endogenous factor and I explained it with that that the granger’s test rather examines which phenomenon occurs first in a statistical viewpoint, than the real causality between series. The results of Lagrange Multiplier test for serial correlation in the residuals and joint significance test of coefficients were all positive at the selected lag-order and the model eigenvalues lied inside the circle. I also provided the forecasted values -generated by Stata software package- to money stock, GDP and interest rate and the values proved accurate only in a year time.

Keywords: Quantitative easing, Vector autoregression (VAR), Granger causality test, Impulse response function, Transmission Mechanism.

Introduction

The central bank aims at achieving higher output growth by lending money to money market at the official rates and conducting open market operations. These rates, in turn, affect the economy in interim, through four main channels, i.e. interest rate, exchange rate, asset pricing and credit channels. In this report, I analyzed the implications of monetary policy of Bank of England between 1990-2011 periods and explained the transmission mechanism and its role in stabilizing the price and balance of account. Further, I explained the output (GDP), money (M3) and long term bond rates (R) by their relative lagged values through vector autoregression and provided a description for the impulse response function. The relative tests for joint significance of VAR coefficients, autocorrelation in residuals (Lagrange Multiplier) and causality test for variables (Granger) are conducted and the forecasted values for output growth, money expansion/contraction and long term interest rates are provided.

Literature Review

After the resign of Ms. Thatcher, the economy was left abysmal (Piers Brendon, 1997). Unemployment rose in the early phases of 1990, consumption dropped to lowest points during 1990-93 years (Crafts N, 1990) and the economy went into severe recession (Andrew Porter, 1999). Apparently, the fall in housing prices had counter influences on the consumption behavior of the population (Roderick F, et al, 1994). Lower net-worth of houses and future expected inflation encouraged savings. Piers Brendon, (1997) however states that the consumption behavior changed during the price fall as people started feeling poorer. Another assumes that the prices got cheaper, the borrowing process got tougher (Arnold A, J, et al, 2004). Hence, Britain was experiencing the toughest moments. Besides, in 1992, Britain membership in ERM was revoked, during which local currency stock fell dramatically (Piers Brendon, 1997). Coming to 1995, housing prices start to crumble up again.

Political administration also played a role in XX’s British economy. In 1997, the employment rate once again soared, although the in-office PM Tony Blair’s labor government was undermined with huge spending plans of the conservative party (Peter Cain and Tony Hopkins, 2001). In 2001, Gordon Brown, successor introduced minimum wage to the country and ended the political power by approving the central bank’s independency (Max Savelle, 2005). The increased borrowings and increased tax revenue subsided invasion to Afghanistan in 2001, and later to Iraq in 2003 (Max Savelle, 2005). Government spending burst for this reason. In a result, 2001 pound reached low against dollar (Cain P.J, et al, 2002).

In 2008, the first quarter of the year, Brian officially went into recession (Steven M, 2009). High commodity prices encouraged the inflation and discouraged business investment (Julian H, 2011). The expectation of recovery was also evident. People start to delay their consumption, or bought import products, making the trade deficit the highest in a decade (Duncan Gary, 2009). Bank of England constantly was constantly striving to handle the situation by decreasing the interest rate to 1 per cent, and later 0.5 to encourage spending and borrowing (BBC News, 2009). At this time Mervin King understood that larger expansionary monetary policy would lead to a liquidity trap, so long term maturity assets were bought and money was injected in the economy. This is also called Quantitative easing in economic terms (Duncan Hugo, 2012). By the year 2009, unemployment jumped to 7.6%. The figures were also showing recession in 2011 as well (Julian H, 2011).

Monetary Policy Committee of UK studied the monetary policy effectiveness of Bank of England, stated that the transmission mechanism in this country do not directly work, as the price level target became the only goal of the policy. And they indicated that the effect of monetary policy is hard to evaluate. To address a similar issue, Lutkepohl. H and Kratzig. M (2002) used a log-linear model using price levels, GDP and money stock to analyze the German economy. It resulted that the causation of money stock in the total output has been optimally determined by its 2-lagged year value. Lie Viet Hung also led a research in Vietnamese case; she used vector autoregression like any other researchers did, and tested for granger causality between inflation and GDP, and found an inter-relationship between these two variables. For UK’s case, ‘monetary policy works largely via its influence on aggregate demand, and has a little affect in supply channel, however, in the long run, it determines the general price level’ says Paul Fisher (2013).

Transmission Mechanism

Transmission mechanism means the process or the processes of how the monetary policy affects the economy and increases the output growth. It goes by four main channels (Mishkin, 2006), and each will be separately described in the paragraphs below.

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Interest rate. Bank of England affects the aggregate demand and influences the borrowing and spending behavior. Here is how. First, it lends largely through constraint maturity gilt sales and repurchases agreements (repo) (Bank of England). The repo rate (official rate) is responded by the market rates as the rates are assumed to be valid for a foreseeable near future. For example the expansionary monetary policy, with the decreased repo rate lowers money-market rates and other short-term rates. The decreased rates stimulate borrowing, since the cost of borrowing now is cheaper and lessens the savings. The borrowed money will be spent in a number of investments and consumption of various products, thus results in an increase in aggregate demand. However, the decreased interest rate favors domestic investment, which implicitly pushes net exports down; and increased interest rates could possibly increase consumption of savers. Therefore, the bank scrutinizes the total consumption behavior and acts upon it.

Interest rate. Bank of England affects the aggregate demand and influences the borrowing and spending behavior. Here is how. First, it lends largely through constraint maturity gilt sales and repurchases agreements (repo) (Bank of England). The repo rate (official rate) is responded by the market rates as the rates are assumed to be valid for a foreseeable near future. For example the expansionary monetary policy, with the decreased repo rate lowers money-market rates and other short-term rates. The decreased rates stimulate borrowing, since the cost of borrowing now is cheaper and lessens the savings. The borrowed money will be spent in a number of investments and consumption of various products, thus results in an increase in aggregate demand. However, the decreased interest rate favors domestic investment, which implicitly pushes net exports down; and increased interest rates could possibly increase consumption of savers. Therefore, the bank scrutinizes the total consumption behavior and acts upon it.

Exchange rate channel. Bank of England buys back its own currencies by selling the foreign assets, including foreign currency reserves to gain appreciation or sells its own currency to gain depreciation (the latter is also called sterilization). By changing the store value of its currency, Bank of England influences on the price indirectly. The chain of effect is following; first, suppose Bank of England sets the official interest rates, thereby shifts the savings function. The change in savings consequently effects on the net capital outflow, which further changes the exchange rate. Now with the appreciation of domestic currency, foreign products become relatively cheaper and stimulus will be put on imports. Meanwhile the domestic production will hurt, and, thus, survives the competition by decreasing the prices. Likewise, depreciation of the domestic currency creates a tendency to a higher inflation. However, the effect on the balance of payment will be delayed due to the process it takes to adaptation (J-curve).

Credit Channel. According to this channel theory, Bank of England monetary policy will influence in interest rates through modified finance premium, which is the difference between funds generated internally and externally (Bernanke). Bank of England will influence the aggregate demand by deficit financing and rediscounting treasury bills. Decreased interest rate mean more reserves and more lending, thus increasing the aggregate demand. But then, the increased interest rate pushes cash flow down, actions - taken against adverse selection and moral hazard (Le Viet Hung) -, become more faint. Thereby, lending become rare practiced by banks and investment, in turn falls and the output declines.

Asset pricing. Bank supervises the repo rate, and prices of stocks, bonds and other assets. The increase in prices yields more wealth and thus increases the aggregate demand. By analogy a person who owns a real asset most probably start thinking wealthier and contributes more of his income in spending. The bank also manages the money supply by using open market operations to fund the government budget deficits. It also supplies one day maturity loans to “banks, security dealers, and building societies” to cover the shortage in the system.

However, the effectiveness of monetary policy is also dependent on the external factors such as business confidence, stages of business cycles in both domestic and foreign level, and the expectations of foreign interest rate (fishers’ effect) and inflation (parity conditions).

Data Source and Description

The data is obtained from the statistics The data is obtained from the statistics database of OECD for its reliability and accuracy. Annual economic indicators [gross domestic product, official interest rates, domestic credit, broad money and exchange rates] were generated between the 1990-2011 periods. The sample data obtained will then be set into series of models and tested for the model error occurred (VEC). I used both Stata and eViews electronic packages to derive the analysis for the selected model. The followings are brief notes for each economic variable:

- Gross domestic product, the total output of the country is calculated with expenditure approach, and given in current local currency units (LCU).
- Official interest rates are the rates at which gilt sale and repurchase agreements are made at two week maturity level (MPC, 2013).
- Domestic credit is the total amount of credit provided by the banks, and also given in LCU
- Broad money is the summation of cash circulation and bank deposits -where money multiplier as the ratio of broad money to base money reflects the relationship of the relative changes of each.
- Credit/Deposit multiplier is the reflection of the changes of base money in loans/deposits made.

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Details

Title
The Implications of UK Monetary Policy (1990-2012)
College
Westminster International University in Tashkent
Course
BSc in Economics with Finance
Grade
90
Author
Year
2013
Pages
22
Catalog Number
V266932
ISBN (eBook)
9783656629023
ISBN (Book)
9783656629016
File size
682 KB
Language
English
Tags
implications, monetary, policy
Quote paper
Nosirjon Juraev (Author), 2013, The Implications of UK Monetary Policy (1990-2012), Munich, GRIN Verlag, https://www.grin.com/document/266932

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