Monetary Policy UK Themes - HOT TOPIC for Paper 2! Must Watch 🔥

Hi everybody, we know that monetary policy is a hot topic area for exams this year. But when questions feature about policy, they're often linked to major themes in the UK economy. So being aware of those themes, being able to choose points better with this knowledge, being able to apply with this knowledge is in your interest and that's exactly what this video is going to do. And in fact, monetary policy in the UK has been fascinating ever since COVID. We can look at it in two phases. The first phase was contractionary monetary policy from COVID recovery all the way through to mid-2024 in two forms. First of all, substantial increases in interest rates, but also quantitative tightening. QT, abbreviated to QT for short, is basically the opposite of QE. Uh where the central bank either sells bonds back into the financial sector, thereby reducing the money supply, or they allow existing bonds that they've held from QE to mature and then remove that value from their balance sheet. The idea of QT is, yeah, to reduce the money supply overall in the economy and to increase long-term interest rates. But the major branch, the major avenue of contractionary monetary policy was higher bank rate. The central bank increasing interest rates from 0. 1% in December 2021 all the way through to 5. 25% by midway of 2024. That's a big interest rate increase and in fact, this happened very quickly um by a lot as well. So this is a big interest rate rise over a short period of time. And the intentions of this contractionary policy was to tame out-of-control inflation. Inflation was super scary, very much a crisis peaking at 11. 1% in October 2022. But in truth, inflation was way above target for a very long period of time. It was genuinely super scary. Um demand-side policies used during COVID sowed the seeds for that high inflation, heavy expansionary fiscal, heavy expansionary monetary policy very much were the major drivers of inflation in the immediate aftermath of COVID. But, then we had the war in Ukraine. That drove up oil and fuel prices, then gas, electricity prices, then food prices. And then that fed through to what the Bank of England called second-round effects. What do we call it? We call it a wage-price spiral. Well, high inflation became anticipated, that fed through to higher wage bargaining and wage expectations, which drove up wages, which then became a major driver of inflation and why inflation was stubbornly high for a long period of time. In fact, it took a long time for wage growth to come down. Only over the last year or so have we seen wage growth ease as the labor market has eased a little bit. So, yes, in response to that, the Bank of England raised interest rates significantly, actually, and inflation came down. But, it took a long time for inflation to come down. It wasn't until 2024 where we saw serious disinflation. That's the time lag argument of monetary policy, right there. Nice evaluation point for you to consider. But, also think about those drivers of inflation. After we had the war in Ukraine, a lot of those were supply-side drivers, right? They're all SRES shifters. Fuel prices, gas electricity prices, food prices, wages are all on the supply side of the economy. But, what do higher interest rates target? What does contractionary monetary policy target? It targets the demand side of the economy. It does nothing to affect those prices that were dominating the high inflation rate. So, there's another evaluation point right there. The cause of inflation is significant in determining the effectiveness of monetary policy in taming inflation. So, did inflation come down because of higher interest rates or because the Bank of England got lucky that those supply-side drivers naturally started to ease? I would argue more so the the But, there were other reasons for increasing interest rates as well, to improve household finances. Uh higher interest rates discourage households taking on debt. That's a beneficial thing overall for sustainability of household finances. In fact, since interest rates went up by a lot, um household bankruptcies have come down a lot. The amount of household debt has come down quite a lot. That's overall a positive thing. But, also higher interest rates encourage more saving. And saving, we know, is a very important safety net in times of economic difficulty for households, right? If unemployment is high, income is lost, or income is lower, you need to fall back on savings to keep your living standards up. So, that's a positive thing as well. But, also, yeah, to promote sustainable growth in the UK economy. With higher interest rates, it means the UK can move away from a debt-fueled growth path, where consumption is fueled by borrowing, where investment is fueled by borrowing. You know, prior to this, interest rates were low for a very long time, for over 10 years, essentially at 0%. Now, at 0% interest, anybody that wants to borrow can do so, whether they need to or not, whether they can afford to or not. That's not sustainable. That's not the type of growth that's

going to keep going over time. Whereas, with higher interest rates, now only consumers that need to borrow and can afford to borrow will do so. Only businesses In fact, you're going to see more spending fueled from savings. investment fueled from retained profit. That's much more organic and sustainable growth for the UK. A strong positive right there. But, we have seen the drawbacks of higher interest rates. For example, the trade-offs with lower growth and higher unemployment as contractionary monetary policy hits aggregate demand negatively. Uh you know, if you've been watching my UK stats video, you must be watching that video for overall awareness of how the UK economy is performing. But, you'll know, having watched that video, that we are stagnating in the UK. Growth has been very poor the last few years. In fact, the back end of 2023, those last two quarters, we had negative growth. That's a recession, isn't it? Two successive quarters of negative growth. High interest rates have played a big part in that. We also know unemployment's been rising. Youth unemployment is on the rise. High interest rates have had a part to play in that as well. And not hugely surprising, the way in which interest rates went up by a lot in a very short space of time has acted as a major demand-side shock to the UK. So, to get those trade-offs isn't that surprising, is it? Also, worry about the impact on the indebted. Those consumers or households with high debt, businesses with high debt, can they afford to pay back those debts with high interest? If not, bankruptcy. Even if they can, worry about the impact on living standards. So, household with mortgage debt, with credit card debt, or general consumer debt, businesses with high business debt, there's the concern right there. And high interest rates, yet another reason for businesses not to invest in the UK economy. You know, investment has been shot ever since we voted Brexit. High interest rates increasing the cost of borrowing, another reason for businesses to be put off investing. And that's terrible for short-run growth, hitting AD. Terrible for long-run growth, hitting LRAS. The last thing the UK economy needed during this phase. Now, this is very, very good to know, right? This phase one contractionary monetary policy. Because think, what are we expecting in the year ahead? We're expecting a stagflationary shock given the effects of the war in Iran hitting the UK economy. And the inflation hit we're going to see is going to be caused by the same major drivers we saw after the war in Ukraine. We've already seen fuel prices go up on the back of higher oil prices. Gas, electricity prices will be next. Food So, understanding this gives us guidance of what we can expect going forward. Are interest rates likely to rise from the Bank of England? I would argue, yes. In which case, we know what the intentions are, what the evaluation to that is. We know what the issues are likely to be as well. Very good when we think forward about what's likely to happen in the UK. But then from mid-2024 up until now essentially, monetary policy flipped. It became much more expansionary, dominated by interest rate cuts. So from August 2024, where interest rates were 5. 25%, they were cut into now where they are at 3. 75%. And the intentions behind that are very much, as we've learned already, to reduce the cost of borrowing, encourage more borrowing for consumption and investment, and try and increase aggregate demand that way to boost growth, to reduce unemployment, which we know is necessary in a stagnating, poorly growing UK economy, but also to improve living standards. That was the intention. Have we seen a lot of that? Well, again, from my UK stats video, we know that the impact has been quite timid, hasn't it? And why is that? Because consumer and business confidence is horribly low. The incentive therefore to borrow, take on more debt simply isn't there for the vast majority of households and businesses in the UK at the moment. But also the size of the cuts. Uh interest rate cuts were very gradual and only by 0. 25 percentage points each time. You're not going to see a huge impact on UK macro performance from such small cuts. Cuts were actually forecast to continue this year. But now with the war in Iran and what we know is coming our way, we're at the end of this cycle. We're going to go back most likely to contractionary monetary policy. So there you have it, guys. An overview of monetary policy themes in the UK. Very interesting stuff. If questions do feature on monetary policy this year, you can choose points really well. You can apply really well. But make sure you're watching all the relevant macro videos on my channel. Make sure you're watching all the videos in my revision for 2026 exams playlist. All of that's going to help you smash it this weekend as your exams approach. Go strong, guys. Thanks for watching this one. Can't wait to see you in future ones as well. —