Reason for Ineffective Monetary Policy

Interest rates refer to the rate at which lenders of money pay interest to their lenders. It is the extra amount of money that a borrower pays above the principle amount that he or she borrowed from a lender.

Investment, on the other hand, refers to the act of saving one’s income, hence deferring consumption. The saved amount's aim is to influence certain tasks with the hope of gaining profit. It refers to the amount purchased per unit time of goods that not consumed, but they are to be used for future production (Hassett 2008).

Expenditure refers to the cost of the factors of production used in producing a product.

Investment expenditures are those costs incurred by the business sector of any economy, on final goods or services. This particularly points at such goods as capital goods. They include, but not limited to: equipment, factor goods etc.

In economics, there exists a network of sectors that add up to complete the entire economy. These are:

i.  The household sector,

ii. The production sector, which refers to, the firms existing in the economy.

iii.The government sector

iv. The rest of the world.

Between the four sectors, there exists a flow of money from one party to another, either as payment in lieu of goods or services. This enables the four sectors to exchange this goods and services and payments smoothly. Each of the sector parties gains some form of benefit from the other in the course of their exchange of goods and services. Firms provide products and services to their consumers in exchange of their expenditure (consumer expenditure). They also acquire factors of production, necessary for the process of production, from the households.

A more complex market situation, however, includes the  presence of other sectors as the inclusion of government expenditure, which consists of the daily activities of the states administrative financial sectors. This sector shows leakages (earned via collection of taxes and other revenues owed to the government), and injections into the economy(which represents the amount of government spending to manipulate the existing state of the economy). In this complex sector, there exists  other leakages, in the form of imports (spending by the households on the rest of the world), and injections, in the form of exports, through the generation of income in the form of foreign exchange.

There exists some form of balance in the economy where the leakages equate to the injections to the economy. This state of balance is the economic equilibrium. For this  balance to hold, the sum of injections must equate that of the leakages from the economy. (Savings + Taxes + Imports = Investment + Government Spending + Exports). However, this is not always the case in most economies. In some instances, the injections might exceed the leakages, leading to a recession, or the opposite case, leading to inflation.

Hence, certain sectors of the economy have to be manipulated to maintain this level of equilibrium. One of the ways in which the government can step in to manipulate the economy, maintaining a state of equilibrium, is by the use of monetary policies.

This refers to the process through which an authorized authority, usually a government institution controls the amount of money in circulation within a given economy. To achieve this, there must be implementation of policies fixing the rate of interests prevailing within the economy, to a level such that the levels of interest rate do not hinder key activities in the economy e.g. investment.

Should the governing authority decide to decrease the level of interest rates prevailing in the economy, the expected results are that businesses shall invest more. This is because the decrease in the cost of borrowing of money. The reduction in interest rates, which in turn leads to the increase in the supply of money, is referred to as an expansionary monetary policy, also known as a reflationary monetary policy.

As is the case, most businesses rely on borrowed funds for businesses to start up their investment activities.   The resulting scenario is that of an increased money supply in circulation. Hence the decrease in the level of interest rates increases the investment demand. This is because companies now do not have to devote their extra resources to the payment of interest on the existing dues. With a general increase in the level of investment, the potential growth of firms is high. However, the stock markets in such economies are also prone to a possibility of loss in value. This means that the currency used in those economies losses value at a rate that equates to that of the decrease in interest rates. The main cause of this is the increased supply of money in the economy, which causes the demand for money to decrease. Hence, households prefer to hold money as liquid and not as investments since they hope to use it in the future for business activities. This refers to the speculative demand for money.

The speculative demand for money refers to the demand for money, not for transaction purposes. this money is, however, held in place of other financial assets. This is  usually because these financial assets are expected to fall in price. A lower interest rate theoretically means that households hold a large amount of money.

In the United Kingdom, the body that holds the authority to manipulate the economy through monetary policies is the Bank of England. The trend in this bank was to cut the monetary policy interest rates from 2008. This was because the credit crunch’ effect became too much a hindrance to economic growth. The confidence of consumers and the business confidence suffered a massive loss due to this credit crunch. Hence the bank reviewed its policies to revise interest rates downwards and by the summer of 2009, the bank rates had declined to 0.5%. This was a point from which there was no return in terms of revision interest rates. The initial aim of the bank was to  boost aggregate demand indirectly, and in the long run, increase the amount of aggregate output.

Theoretically, this reflationary monetary policy has positive results. Some of these include:

•  Less interest debts for mortgage payers, hence an increase in the households’ disposable income.

•  Loan availability at a cheaper price,

•  Since the cost of consumer credit is low, there is an increase in  purchases in such big- ticket items as cars and other expensive goods.

•   The hope that with the prevailing low interest rates, the sterling pound depreciates in value. This in turn supposedly  leads to an increase in export levels from the United Kingdom, and hence an increase in the competitiveness level of this sector.

• In the long run, the presence of low interest levels ought to improve the level of consumer confidence, increasing the level of consumption. It should also improve the level of business confidence, hence increasing the level of investments.

However, this is not the case, according to critiques, who argue that the low interest rates that prevail in the United Kingdom economy have little or no effect on the desired investment expenditure. This can be attributed to several factors. Moreover, the levels of confidence that exist in the economy are low, hence necessitating some sectors to refrain from participating in some activities.

Some banks in the United Kingdom refrain from lending to the public.  (Riley 2012)They resolve to being risk averse reducing the amount of money they offer as loans to the public in fear of suffering losses. This leads to the difficulty in obtaining credit in the case of firms.

There exists a looming recession in the economy, according to critics. This leads to the decline in the level of consumer confidence in the existing market conditions. The households in this economy therefore, refrain from undertaking in large purchases.  (Riley 2012). This is because they have also, become risk averse, mainly due to the low level of interest elasticity of demand caused by the weak expectations in the overall market performance.

Another reason as to why desired investment demand responds slightly to the low level of interest rates, that exist in the United Kingdom is that, the government also has looming enormous debts, inclusive of a 200 Billion debt owed for credit cards.

Another reason is the lack of assurance that the levels of asset prices (Riley 2012), which fluctuate frequently due to the low levels of interest rates, shall offer any form of boost to the housing and real estate’s sectorial markets in the economy.

Moreover, there is an observation that although the monetary policy interest rates are almost approaching zero, the rate charged by commercial banks for loans, and overdrafts is the opposite. It is increasing, hence the cost of borrowing via the use of credit cards and loans increases, as a result. Hence the small businesses in the United Kingdom view the reduction in interest rates, not as a way of benefiting them, but as a policy of ‘cheap money’ that does little to improve their efforts of gearing up from the looming recession state prevailing in the economy. The interest rates do little to aid them in the early stages of recovery from the recession.

All the above discussed arguments show how the level of consumer confidence in the economy of the United Kingdom, has, over the years declined to alarming rates. This is more- so as a result of the recession that prevails in the economy. Hence the expected results of lowering the interest rate, which, in a normal scenario, would amount to the increase in the level of aggregate demand, ends up reducing the  aggregate demand level in the economy. The level of investment expenditure is also acutely affected by these low levels of interest rates, since potential would be investors end up losing their trust in the possibility of any form of recovery from the recession. Hence the amount of costs that they sacrifice as investments is remarkably little (Sloman 1999).

This translates to a slow growth rate in investments, caused by the low level of consumer and business expenditure.