Explain how The Monetary Policy Committee controls inflation within the UK economy.

The Monetary Policy Committee’s primary role is to control inflationary pressures within the UK economy to achieve a target of 2% inflation and sustain price stability. The Monetary Policy Committee controls money supply within the economy and hereby controls inflationary pressures by changing the base rate of interest. Firstly, there are two causes of inflation, demand-pull and cost- push. Demand- pull inflation occurs when aggregate demand in the economy is higher than aggregate supply, and so, the total demand in economy exceeds its productive capacity resulting in the price level being “pulled up”. Cost-push inflation occurs through an increase in the production costs for firms within the economy which are passed onto consumers in the form of higher prices, and so, in this way the price level is “pushed up”. However, changes in the interest rate generally has very little effect on inflation if it is caused by cost push factors e.g. an increase in the cost of the inputs of production. Therefore, it may be more useful to assess how changing the base rate of interest may be used to control demand-pull inflation. An increase or decrease in the base rate of interest has a corresponding effect on aggregate demand due to its effect on consumption, investment and import prices. If the committee increases the interest rate then it is more expensive to borrow and saving becomes more attractive, therefore consumption in the economy will fall. This fall in consumption may be aided by the effect that an increase in interest has on mortgage repayments. When the interest rate increases, so does the mortgage repayments for those who opt to track the interest rate rather than have a fixed rate mortgage. Therefore, for many consumers, an increase in interest rates can greatly decrease their disposable income, leading to further reduced consumption. Furthermore, the increase in interest rates leading to borrowing being more expensive leads to a fall in investment and as consumption and investment are both components of aggregate demand, we can see that a rise in interest rates will enable the Monetary Policy Committee to control demand- pull inflation. Additionally, when interest rates increase there tends to be an increase in flows of hot money into the economy which leads to an increase in the demand for pound sterling. As a result, there is an appreciation in the value of the pound due to the laws of supply and demand, and so, exports become more expensive and imports become cheaper. This will ultimately lead to a fall in domestic aggregate demand through domestic consumption demanding more imports and the demand for UK export falling. Therefore, in a similar manner, by increasing interest rates The Monetary Policy are able to control demand-pull inflation. Thus, The Monetary Policy Committee control rising inflationary pressures within the UK economy by increasing the base rate of interest which ultimately leads to a corresponding decrease in aggregate demand that restricts inflationary pressure.