On 2 November, the Bank of England raised the interest rate – the first rise sin

Question

On 2 November, the Bank of England raised the interest rate – the first rise since July 2007, although the Office for Budget Responsibility had revised down its forecasts of growth in productivity and real GDP. There are three main arguments:

Inflation, at 3%, is above the target of 2% and is likely to stay above the target if interest rates are not raised.

There is little spare capacity in the economy, with low unemployment. There is no shortage of aggregate demand relative to output.

With productivity growth being negligible and persistently below that before the financial crisis, aggregate demand, although growing slower than in the past, is growing excessively relative to the growth in aggregate supply.

If recent forecasts have downgraded productivity growth and hence long-term economic growth, does this support the argument for raising interest rates or does it suggest that monetary policy should be more expansionary?

Inflation, at 3%, is above the target of 2% and is likely to stay above the target if interest rates are not raised.

There is little spare capacity in the economy, with low unemployment. There is no shortage of aggregate demand relative to output.

With productivity growth being negligible and persistently below that before the financial crisis, aggregate demand, although growing slower than in the past, is growing excessively relative to the growth in aggregate supply.

Explanation / Answer

Ans. The above three main arguments about the forecast of growth in productivity and real GDP supports the argument that the monetary policy of Bank of England should be more expansionary. Though the inflation is higher than targeted and the unemployment level is low but this inflation is due to excessive demand and relative lower aggregate supply in the economy. More people are running for fewer goods. So, in this scenario, an expansionary monetary policy would help in boosting investment, which will increase money supply and thus the aggregate supply will increase and funds will also go towards R&D related works which will help in increasing productivity and thus lastly the real GDP will also increase.

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