How Monetary Policy Affects Aggregate Demand in UK

In the UK, monetary policy has been quite flexible and have consequently adapted to adjustments after the 2008/ 2009 international financial crisis. The monetary policy has since been adjusted to address various gaps that were identified from the onset of the global crisis. UK has have constantly used the monetary policy in stabilizing the economic performance especially after the 2008/ 2009 global financial predicaments (Langdana, 2009).

The monetary policy aims at regulating the aggregate demand through physically controlling the demand and supply of money as well as controlling the interest rates. The reason behind the downward slope of the curve of AD is assumed to be wealth effect, effect of the interest rate and the effect of rate of exchange. The monetary policy seeks to adjust these effects for a stable functioning of the economy. Monetary policy puts into consideration the Keynes theory of liquidity in establishing control mechanisms for the AD curve shift. The theory postulates effective means of controlling money supply and demand. Monetary policy uses this underling concept to regulate AD and the whole economy in the long-run (Cobham, 2002).

According to Cobham (2002), the tools of monetary policy under which central bank uses to control the supply of money are; the open market operations, controlling the reserves, and adjusting the rate of refinancing. Since it’s the central bank that decides on the amount of money to supply, the interest rate does not influence the money supply. This supply is represented by a vertical curve of supply. On the other hand, the central bank uses the monetary policy in controlling the demand for money. Liquidity preference theory states that interest rate is the most important factor of concern in regulating the demand of money in the economy. The theory highlights that people prefer holding on liquid cash than assets generating high returns due to instant acquisition of goods and services. To reduce the quantity of money demanded, the central bank increases the interest rate hence raising the cost of holding money which translates to reduced demand of money.

The monetary policy aims at maintaining the supply and the demand for money at equilibrium. Liquidity preference theory suggests that interest rate determines this demand and supply. The central bank on the other hand sets the rate of interest at a level which will equate the supply and demand for money. This rate is referred to as the equilibrium rate. Equilibrium rate of interest limits the escalation of either supply or demand of money hence stabilizing the economy. The figure below indicates the equilibrium in the money market and signifies how the central bank uses the monetary policy to regulate the AD.

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