Government’s main macroeconomic objectives are to maintain low and stable rates of inflation and high levels of economic growth. Inflation is defined as a persistent increase in the average price level in the economy. Economic growth is an increase in national income. These two policy objectives contradict each other on the topic of monetary policy which is the official policy that overviews the supply of money and levels of interest rates. The Bank of England ‘remains divided on when to tighten monetary policy.’ They must choose to hold interest rates in order to maintain inflation at the current 1% level or, to raise interest rates and reduce aggregate demand. Aggregate demand is the total spending on goods and services in a time period at a given price level.
Currently the United Kingdom’s ‘weak inflation’ is caused by the collapse of oil prices. This is an example of a demand pull inflation, in which there is too much demand for a product that has limited supply. Oil, being an essential commodity to the economy, the low prices cause the aggregate demand to shift out (AD1 ‘ AD2) and real output also shifts out (Y1 ‘ Y2).
Also, the decrease in the price of oil advertently leads to a lower cost of production allowing for the short run aggregate supply curve outward (SRAS ‘ SRAS1). At a given price level, all goods and services produced in a country is called aggregate supply.
Effect of low oil prices and low higher interest rates:
The inflation rate is so low that the UK could go into deflation, in which the value of the currency would rise and for those with jobs that were inflation-linked, no longer have to experience a loss in purchasing power, which leads to an increase in living standards. Overall, a huge rise in consumer consumption. Due to this deflation, the Bank of England has no pressure to raise the interest rates just yet. They must decide when to apply contractionary monetary policy. Khan states that due to a ‘slowdown’ in manufacturing and services, there is a delay is ‘rate hikes.’ Interest rates primarily affect aggregate demand because if the rates are high, there is less of an incentive to borrow money than it is to save because it costs more. People would prefer to keep their money in the bank and earn money rather than spend it. An increase in interest rates leads to a fall in consumption. Investment money can come from a firm’s ‘retained profits.’ If the interest rates are high, the firms would most probably place the money in the bank to gain money as savings. A decrease in the rate would decrease the incentive to save and rather to invest. Investment and consumption are two components of aggregate demand.
Monetary policy is the most effective way of handling aggregate demand using changes in interest rates to go against inflation. In addition, demand side policies are inefficient because they will decrease the national output and the price level. In contrast, supply side policies decreases the price level yet increases the national output.
Effect of Supply Side Policies:
The long run aggregate supply can be extended with the improvement of the quantity and quality of the factors of production. Overall, supply side policies are effective in the long run.
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