Purpose Of Controlling The Interest Rate Expense

Published Date: 02 Nov 2017

The Central Bank is considered to be the main pivot cog that regulates the money supply in the country. Forex traders defines Central Bank as a financial institution charged with the responsibility to manage the regularity of the size of a nation’s money supply, the management of providing credit and at the same time keeping a check on the foreign exchange value of its currency. (Forextraders.com, 2012)

The roles of the central bank however vary from country to country but all that had in common includes the addressing of the issues such as:

The extent of the central bank’s ability to design policy and to implement these policies. They would also cover addressing issues which includes determining the exchange rate policy and the setting of the objectives that includes both monetary and exchange rate policies.

The extent of the central bank’s ability to hold the responsibility for the financial stability of the whole country. This would include addressing the questions as to the instruments available at its disposal to discharge its responsibilities.

How the central bank did would ensure a balance between the various infrastructure systems that are the pillars to support the payments and the settlement systems.

What are the other financial and non-financial functions that would fit with the overall monetary and fiscal policy and the financial stability task? (David Archer, 2012)

The Bank of England purpose is to ensure the provision of monetary stability and to contribute towards the financial stability of the country. (Bank of England, 2012a)

Monetary Policy Committee is in charge of setting up the interest rate for the Bank of England. (Bank of England, 2012b)

The committee meets every month to decide on changing the level of interest rate In the economy. (Bank of England, 2012b)

Interest rate being defined as cost of borrowing money is integral part of any economic system around the globe. It is sometimes treated as a variable to control or influence other variables in the macro economy to achieve the desired results. The activity of the interest rate can be found at any level with a supplier relying on overdraft amount from the bank to supply to its customer on credit, with customer paying through its overdraft account, with business investing money in the savings account of the business, with near end of retirement people investing their amount in pension funds every transaction encompass at some level the effect of interest rate.

In December 2012 the Bank of England decided to maintain the level of interest rate at 0.5% and the size of the Assets Purchase Program being set at £375 billion. (Bank of England, 2012c)

The level of interest rate has been maintained at a constant level of 0.5% since 5th March 2009. (Bank of England, 2012c)

The purpose of controlling the level of interest rate is that it is considered to be one of the prime macroeconomic indicator that could be used to influence the other macroeconomic indicators for instance unemployment rate, level of inflation and the exchange rate of the national currency.

According to the Trading Economies, the mean level of unemployment rate is 8.05% during 2012 with the highest rate of unemployment being 8.4% in the month of January and the lowest being 7.7% in the month of December. (Trading Economies, 2013)

Whereas the inflation rate during the same period stood at an average of

Purpose of Controlling the interest rate expense

The purpose of controlling the interest rate level was due to control the level of unemployment and the inflation rate within the economy. This is further depicted from the understanding and form the study of the data that has been gathered over the years.

Theories associated with the level of interest rate

Phillips curve explains the relation between the level of interest rates and the level of unemployment rate.

In 1958 AW Phillips plotted 95 years of data of UK wage inflation against unemployment. It seemed to establish a short-term relation between unemployment and inflation. (Investopedia, 2013a)

The rationale behind this, that was established, was fairly straightforward. Falling unemployment was associated with rising inflation and with rate of unemployment increasing the inflation rate would be falling.

It was argued that if the government wanted to increase employment rate in the economy it could do so by creating job opportunities. Increasing job opportunities means more activity within the economy which would result in increasing country’s output and hence increasing GDP of the economy but, although this might result in job creation, it might also lead to impacting having inflationary implications in the labor and the product market.

The rationale that was put forward for this reaction was that when additional jobs are created this would not only shift the aggregate demand curve to the right but also shift the aggregate supply curve to the right. Sometimes, the effect on the aggregate demand curve and on the aggregate supply curve would not be the same hence this might sometimes result in inflationary pressure on labor and the product market.

After the introduction of Phillips curve, Milton Friedman criticized the basis for the original Phillips Curve and then introduced the concept of the NAIRU, which is defined as the rate of unemployment when the rate of wage inflation is stable. (Investopedia, 2013b)

The NAIRU is defined as the unemployment rate consistent with steady inflation under a specified set of conditions. It is meaningful only within a well-specified model of the inflation process. This is depicted by the introduction of the "triangle model" of the inflation process that incorporated and resurrected the Phillips curve from what Lucas and Sargent (1978) had called the "wreckage" of the early and mid 1970s. (NBER, 2013a)

Another development in terms of establishing a relation between these two variables i.e. the interest rate and the inflation rate was that developed by Friedman. (Investopedia, 2013b)

Friedman accepted that the short run Phillips Curve existed – but that in the long run, the Phillips Curve should be drawn as vertical and, as a result, there was no trade-off between unemployment and inflation. (Investopedia, 2013b)

He argued that each short run Phillips Curve was drawn on the assumption of a given expected rate of inflation. So if there were an increase in inflation caused by a monetary expansion and this had the effect of driving inflationary expectations higher this would cause an upward shift in the short run Phillips Curve.

Wage Price Spiral (effecting the inflation rate)

For a long time, the "wage price spiral" was a central element of macroeconomic dynamics. An increase in aggregate demand, it was argued, would increase output and employment, leading firms to desire higher prices and workers higher wages; this would start a wage price spiral, which would end only if and when this "demand pull" inflation decreased real money balances sufficiently to return the economy to steady state. Or the spiral could start from a desire from workers to increase their real wages, or from firms to increase their profit margins, or from the attempts by both sides to maintain the same wage and price in the face of an adverse supply shock these would also start a wage price spiral, lead to "cost push" inflation, and through the effect of inflation on real money balances, lead to a recession. With the advent of rational expectations, the wage price spiral left center stage. (NBER, 2013b)

With rational expectations, workers and firms had to understand that there could not be a simultaneous increase in all real wages and all markups (of prices above wages). The effect of an increase in aggregate demand was to increase nominal wages and prices simultaneously and instantaneously, in order to decrease real money balances and leave output unchanged. The same reasoning applied to supply shocks. Workers and firms had to understand that either real wages or profit margins or both had to decrease; the adjustment was instantaneous. (NBER, 2013b)

Price level dynamics are indeed the result of attempts by workers to maintain (or increase or decrease as the case may be) their real wage and by firms to maintain (or increase or decrease) their markups. Furthermore, there is a direct relation between the inflexibility of real wages and markups to shifts in demand and the degree of price level inertia. The smaller the effect of shifts in the demand for goods on the markup, and the smaller the effect of shifts in the demand for labor on the real wage, the more slowly will the nominal price level adjust to offset aggregate demand disturbances. (NBER, 2013b)

As the nominal price level adjusts slowly to its equilibrium value, changes in nominal money have long lasting effects on real money and aggregate demand. If movements in aggregate demand are not too large, in a sense to be made precise later, aggregate demand determines output suppliers willingly accomodate the increased demand for goods and labor. (NBER, 2013b)

Finally, if the economy is predominantly affected by aggregate demand shocks, there is, as a first approximation, no relation between output and real wage movements. In response for example to an increase in nominal money, output temporarily increases before returning back to its equilibrium level.

During this adjustment process, the real wage is neither systematically lower nor higher but simply oscillates around its equilibrium value. (NBER, 2013b)

Policy in the real life context by considering the UK economy

http://www.tutor2u.net/economics/revision-notes/a2-macro-phillips-curve_clip_image007.gif

(Source: Investopedia, 2013a)

In the late 1980s the UK overheated and suffered a sharp rise in inflation. Unemployment was falling (the economy was moving up a short run Phillips Curve) but the loss of control over inflation caused 15% interest rates and eventually a painful recession that caused unemployment to rise to nearly 10 per cent. Higher unemployment helped to bring inflation down once more but the cost was heavy.

The period from 1993 through to 2005 was a remarkable one for the UK. We saw a sustained decrease in the unemployment rate, yet consumer price inflation remained low and fairly stable. Indeed in the mid 1990s both unemployment and inflation were on a falling trend and this was evidence of an improvement in the inflation-unemployment trade-off. (Investopedia, 2013a)

From 2006 onwards the picture began to change. Inflation edged higher from below the 2% target to 3% in the spring of 2007. Unemployment levelled off with the claimant count measure flat lining at 3% of the labour force. But in 2008 there was a sharp pick up in inflation with prices driven higher by a combination of higher fuel and food costs. The rate of inflation peaked at 5.2% in October 2008 just at the time when unemployment started rising again with the economy slowing down and then entering recession. (Investopedia, 2013a)

In 2008 the big policy danger was thought to be a return to stagflation – a combination of weak growth, high inflation and rising unemployment. (Investopedia, 2013a)

In the event the inflationary dangers ebbed away in 2009 as recession started to bite and global commodity prices fell back down. Indeed with unemployment rising and inflation falling, the policy risk has switched to the dangers of a deflationary recession – a combination of high unemployment and falling prices. (Investopedia, 2013a)

In 2010 the rate of unemployment stabilized but inflation picked up once more to 3% - driven higher by rising commodity prices and a low exchange rate. Fears of stagflation returned with the British economy struggling to maintain a decent recovery but with inflation rising above 5%. (Investopedia, 2013a)

Conclusion:

The purpose of controlling the interest rate policy is actually to control the level of inflation and unemployment rate in the country.