Business bank

External

Finance

Planning

External environment - Role of the Bank of England

Explanation

Interest rates in the UK economy are set by the Monetary Policy Committee (MPC) of the Bank of England. This has been the situation since 1997 when the government gave operational independence to the Bank of England. The MPC are set an inflation target (currently 2%) and they have to maintain inflation within 1% either side of this target. If inflation goes outside this range then the Governor of the Bank of England has to write an open letter to the Chancellor of the Exchequer explaining why they have missed the target and what they will be doing to bring inflation back within the range.

To work out what to do with interest rates, the Committee will look very carefully at a wide range of factors that can contribute to the pressure on prices to rise in the economy over the next two to three years (inflationary pressures). Each of these contributes in differing degrees to the level of demand in the economy, as excess demand will tend to increase prices. If the level of aggregate demand (AD) in the economy is growing strongly this could lead to a rise in the general price level. This is known as demand-pull inflation. If the MPC feel that the level of demand is likely to be too high in the coming months, then they will put interest rates up to try to reduce the growth of demand. This should help stop inflation rising. However, if they feel demand growth is likely to be too slow they will cut interest rates to try to boost the economy.

Cutting interest rates is termed a reflationary policy, whereas a rise in interest rates is called a deflationary policy.

The MPC has nine members. Five of them are from within the Bank of England and include the Governor and two Deputy Governors; the other four are called external members and are appointed by the Chancellor. At each monthly meeting the members vote on what they believe should happen to interest rates. If the vote is equal, then the Governor of the Bank of England has the casting vote. The minutes of all the meetings are published shortly after the meetings.