AQA Specification focus:
‘The role of the Monetary Policy Committee of the Bank of England (MPC) and how it uses changes in bank rate to try to achieve the objectives for monetary policy, including the government’s target rate of inflation.’
The Monetary Policy Committee (MPC) is central to the UK’s economic stability, using the Bank Rate as its main instrument to control inflation and guide economic performance.
The Role of the Monetary Policy Committee (MPC)
The MPC is a committee within the Bank of England responsible for setting the official Bank Rate. Its primary purpose is to deliver price stability, defined by the government as achieving a specific inflation target, while also supporting wider economic objectives such as growth and employment. The MPC was established in 1997 to ensure that monetary policy decisions are made independently of short-term political pressures.
Membership and Independence
The MPC typically consists of:
The Governor of the Bank of England
Deputy Governors for monetary policy, financial stability, and markets/banking
Chief Economist of the Bank
A number of external members, appointed for expertise
This composition ensures a balance between internal expertise and external perspective. Independence means that decisions are made based on economic evidence, not political convenience.
The Bank Rate
The Bank Rate (sometimes referred to as the base rate) is the rate of interest the Bank of England charges on short-term loans to commercial banks.
Bank Rate: The official interest rate set by the Bank of England that influences borrowing, lending, and overall economic activity.
By changing the Bank Rate, the MPC can influence the cost of credit and the incentive to save, which in turn affects aggregate demand.
How Bank Rate Changes Affect the Economy
Raising Bank Rate: Increases borrowing costs, reduces consumer spending and investment, lowers inflationary pressures.
Lowering Bank Rate: Reduces borrowing costs, stimulates demand, can increase inflationary pressures.
The Bank Rate is a powerful lever but operates with time lags; its full effects may take up to 18–24 months to filter through the economy.
The Inflation Target
The government sets an official inflation target, currently at 2% (CPI). The MPC must use monetary policy tools, particularly adjustments to the Bank Rate, to try to keep inflation close to this target.
Inflation Target: A government-set objective, expressed as a percentage change in the Consumer Prices Index (CPI), designed to maintain price stability.
If inflation deviates significantly from the target (by more than 1 percentage point above or below), the Governor must write an open letter to the Chancellor explaining why, what action is being taken, and how long it is expected to take to return inflation to target.
Interaction Between MPC, Bank Rate, and Inflation Target
The MPC uses changes in the Bank Rate to manage the balance between price stability and wider macroeconomic goals. This involves considering:
Current and forecast levels of inflation relative to the target
Economic growth and unemployment rates
Exchange rate movements and their effect on import prices
Global economic conditions
Transmission Mechanism Overview
Although covered in more depth elsewhere, the essential idea is:
Bank Rate changes affect commercial bank lending and saving rates.
This alters consumer spending, investment, and aggregate demand.
Changes in demand affect inflationary pressures relative to the target.
The Decision-Making Process of the MPC
The MPC meets regularly (usually monthly) to review:
Latest inflation data (CPI trends)
Economic growth forecasts
Labour market conditions
External shocks such as oil price changes or currency movements
At each meeting, members vote on whether to raise, lower, or maintain the Bank Rate. The decision is announced publicly with explanations to ensure transparency.
Key Considerations
If inflation is above target, the MPC may raise the Bank Rate to cool demand.
If inflation is below target, the MPC may lower the Bank Rate to stimulate demand.
If inflation is on target but risks loom (such as external shocks), decisions may be pre-emptive.
The MPC adopts a medium-term and forward-looking approach to determine the monetary stance required to achieve the inflation target sustainably.
Limitations of the Bank Rate in Achieving the Inflation Target
While adjusting the Bank Rate is central, there are limitations:
Time lags mean policy effects are not immediate.
External shocks (e.g., rising oil prices, global recessions) can disrupt inflation regardless of domestic policy.
Zero lower bound: Interest rates cannot be cut below zero beyond a certain point without damaging side effects, limiting effectiveness during deep recessions.
To overcome these limitations, the MPC may also use additional tools such as quantitative easing or forward guidance, but these are outside the strict focus of this subsubtopic.
Summary of Key Points
The MPC is tasked with achieving the government’s inflation target.
The main tool is the Bank Rate, adjusted to influence borrowing, saving, and spending.
Decisions are evidence-based, independent, and transparent.
Achieving the target is complex due to lags, external shocks, and practical constraints.
FAQ
If inflation deviates by more than 1 percentage point either side of the 2% target, the Governor of the Bank of England must write an open letter to the Chancellor.
Persistent failure can reduce public and market confidence in monetary policy. It may also encourage debate about whether the Bank Rate alone is sufficient or if additional tools are required.
The Bank Rate directly influences the cost of borrowing and the return on savings.
It transmits through commercial bank interest rates.
It influences household spending, business investment, and exchange rates.
It is flexible and can be adjusted regularly through MPC meetings.
Other tools, such as quantitative easing, are used mainly in exceptional circumstances.
Higher Bank Rates tend to attract foreign capital, increasing demand for sterling and causing appreciation.
Lower Bank Rates make sterling less attractive, reducing demand and often leading to depreciation.
This exchange rate movement feeds back into inflation by affecting the cost of imports and exports.
Monetary policy works with time lags of up to two years.
If the MPC waited for current inflation to move before acting, policy changes would take effect too late. Forecasting and anticipating future inflation trends ensures policy is proactive rather than reactive.
External shocks can undermine the effectiveness of Bank Rate changes.
Examples include:
Global oil price increases driving up costs regardless of domestic demand.
Currency fluctuations caused by international events.
Geopolitical instability influencing confidence and investment.
These factors can cause inflation to move away from target, even when domestic demand is stable.
Practice Questions
Define the term Bank Rate and explain briefly how it influences borrowing in the economy. (2 marks)
1 mark for a correct definition: the official interest rate set by the Bank of England/MPC.
1 mark for explaining influence on borrowing: higher rate makes borrowing more expensive/reduces demand for credit OR lower rate makes borrowing cheaper/increases demand.
Explain how the Monetary Policy Committee (MPC) uses changes in the Bank Rate to achieve the government’s inflation target. (6 marks)
Up to 2 marks for reference to the inflation target (e.g. 2% CPI, set by government, ensures price stability).
Up to 2 marks for accurate description of how changing the Bank Rate influences borrowing, saving, and aggregate demand.
Up to 2 marks for linking Bank Rate adjustments to inflation outcomes (e.g. raising rates reduces demand and lowers inflationary pressure, lowering rates boosts demand and may raise inflation).
Maximum 6 marks.
