AQA Specification focus:
‘The current objectives of monetary policy set by the government.’
Introduction
Monetary policy in the UK is designed to achieve government-set objectives that balance growth, stability, and fairness. These goals guide the Bank of England’s Monetary Policy Committee (MPC).
The Purpose of Government-Set Objectives
The UK government defines specific targets to ensure monetary policy supports both short-term stability and long-term growth. These objectives give the central bank a framework for decision-making and help anchor expectations among households, firms, and financial markets.
Key Objectives of Monetary Policy
1. Price Stability
The primary objective of monetary policy is to maintain low and stable inflation.
Price Stability: A situation where the general level of prices in an economy rises at a slow, predictable rate, avoiding both high inflation and deflation.
The government currently sets an inflation target of 2% (CPI).
This provides a benchmark against which the MPC evaluates its policies.
If inflation deviates by more than ±1 percentage point, the Governor of the Bank of England must write an explanatory letter to the Chancellor.
2. Economic Growth and Employment
Although price stability is the priority, monetary policy also aims to support sustainable economic growth and high employment levels.
Growth should be non-inflationary, meaning demand increases without overheating the economy.
High employment reduces social costs, such as welfare dependency and income inequality.
Sustainable Growth: Economic expansion that can be maintained over the long run without creating inflationary or environmental pressures.
3. Balance of Payments Stability
The government also considers the UK’s external position.
Exchange rate stability helps ensure export competitiveness.
Avoiding large trade deficits protects against external shocks and dependence on foreign capital.
Monetary policy can indirectly affect this objective through interest rates and exchange rate movements.
4. Financial Stability
A crucial objective is ensuring the stability of the financial system.
Preventing excessive credit growth reduces the risk of asset bubbles.
Stable financial markets underpin confidence, encourage investment, and protect the wider economy.
The global financial crisis of 2007–08 highlighted the importance of this goal.
Financial Stability: A condition where financial institutions, markets, and infrastructure function effectively, and shocks do not threaten the economy.
The Role of the Bank of England and the MPC
The Bank of England’s Monetary Policy Committee (MPC) is responsible for achieving these objectives.
Its decisions focus mainly on interest rates (Bank Rate).
Secondary tools include quantitative easing and forward guidance.
While independent in day-to-day operations, the Bank works within the government’s mandate.
Trade-Offs Between Objectives
Inflation vs Growth
Tightening monetary policy (higher interest rates) reduces inflation but may slow growth and raise unemployment.
Loosening monetary policy boosts demand and jobs but risks higher inflation.
Stability vs Competitiveness
Keeping interest rates high stabilises prices but strengthens sterling, reducing export competitiveness.
Lower rates can weaken the currency, boosting exports but risking higher import prices.
How Objectives Guide Policy Decisions
When setting the Bank Rate, the MPC considers:
Inflation forecasts relative to the 2% target.
Growth projections and employment levels.
Risks to the balance of payments from exchange rate movements.
Threats to financial stability, such as rising household debt.
This ensures monetary policy is not just reactive but forward-looking, aiming to maintain stability while enabling long-term prosperity.
Broader Context of Government Objectives
Beyond economics, monetary policy objectives contribute to political and social goals:
Protecting household purchasing power.
Encouraging business investment by reducing uncertainty.
Ensuring fairness between savers and borrowers.
Supporting confidence in UK institutions and the pound.
These broader aims show that government-set objectives for monetary policy extend well beyond the technical task of controlling inflation.
FAQ
The 2% target is considered low enough to prevent the economy from suffering the costs of high inflation, such as loss of competitiveness and reduced purchasing power.
At the same time, it avoids the risks of deflation, which can discourage spending and investment. A small, predictable rise in prices encourages firms to invest and households to consume without destabilising the economy.
Monetary policy objectives focus mainly on price stability, growth, employment, external stability, and financial system resilience, with tools such as interest rates and quantitative easing.
Fiscal policy, by contrast, targets government spending, taxation, and borrowing to influence demand, redistribute income, and fund public services. While they overlap, monetary policy is operationally independent and designed to deliver stability, whereas fiscal policy often pursues political and distributional goals.
If inflation remains persistently above or below the 2% target, credibility may weaken, leading to unanchored expectations among firms and households.
This can increase wage-price spirals if inflation is high, or discourage investment and growth if inflation is too low. Ultimately, repeated failure could prompt political debate about adjusting the Bank of England’s independence or revising the target itself.
Financial stability underpins all other objectives, since without a functioning banking and credit system, achieving growth, stable prices, or balance of payments equilibrium becomes impossible.
Government-set objectives therefore require the Bank to monitor:
Household and corporate debt levels.
Risks of asset bubbles in housing or stock markets.
Resilience of banks and lenders.
This ensures shocks in financial markets do not destabilise the real economy.
Conflicts arise because achieving one objective can make it harder to achieve another. For example:
Raising interest rates may bring inflation back to target but also slow growth and increase unemployment.
Lowering rates to stimulate jobs and growth may weaken the currency, raising import prices and inflation.
These short-term trade-offs mean the MPC must balance objectives, prioritising inflation but considering the wider economy.
Practice Questions
State the current government-set target for inflation in the UK and explain why maintaining this target is important for the economy. (2 marks)
1 mark for correctly stating the target inflation rate of 2% CPI.
1 mark for explaining why it is important, e.g. it maintains price stability, prevents high inflation or deflation, or anchors expectations for households and firms.
Explain two government-set objectives of UK monetary policy apart from the inflation target, and analyse why they may sometimes conflict with each other. (6 marks)
Up to 2 marks for identifying two valid objectives (e.g. sustainable economic growth, high employment, balance of payments stability, financial stability).
Up to 2 marks for explaining the objectives, e.g. growth should be non-inflationary, financial stability reduces risk of crises, etc.
Up to 2 marks for analysis of potential conflicts, e.g. expansionary policy may support growth and employment but risk higher inflation, or high interest rates may reduce inflation but harm growth and competitiveness.
