Monetary policy

The Bank of England, the MPC and the 2% target; Bank Rate and quantitative easing; the transmission mechanism, real interest rates and the limits of monetary policy.

Bank Rate: 3.75%.

Bank Rate has been 3.75% since December 2025. On 17 September 2026 the Bank of England’s Monetary Policy Committee voted 6–3 to hold it there, with three members wanting a rise to 4%, as inflation stayed above the 2% target. The next decision is due on 5 November 2026.

How can one interest rate change prices across the whole economy?

Source: Bank of England, Monetary Policy Summary, September 2026.

Monetary policy.

Monetary policy is the use of interest rates and the money supply to influence the economy. In the UK it is run by the Bank of England, operationally independent of the government since 1997.

• The Monetary Policy Committee (MPC) has nine members and meets eight times a year.
• The government sets its target: 2% CPI inflation.
• Its main tool is Bank Rate, the rate it pays on banks’ reserves. Other interest rates tend to follow it.
• Quantitative easing (QE): creating new money to buy bonds, pushing down long-term interest rates when Bank Rate is already very low.
• The target is symmetric: inflation too far below 2% is as much a concern as inflation above it. If inflation is more than 1 percentage point away from 2%, the Governor writes an open letter to the Chancellor explaining why.
• The Bank also works for financial stability, and is the lender of last resort: it lends to banks that run short of cash, to stop a bank failure spreading.

How a rise in Bank Rate reduces AD.

• Saving and borrowing: saving pays more and borrowing costs more, so households spend less (C falls) and firms invest less (I falls).
• Mortgages: households on variable rates pay more each month, leaving less to spend.
• Asset prices: house and share prices tend to fall, so people feel less wealthy and spend less.
• The exchange rate: the pound rises, making exports dearer and imports cheaper, so net exports fall.
• Confidence: people and firms expect slower growth and hold back.

Why it may not work as planned.

• Time lags: the full effect of a rate change takes up to two years. Many mortgages are fixed for two or five years, so they only feel a change when they renew.
• Cost-push inflation: if inflation comes from higher energy or import prices, raising rates cuts output and jobs without dealing with the cause.
• Confidence: in a deep downturn, cheap borrowing may not persuade worried households and firms to spend.
• The lower limit: rates cannot go much below zero, which is why QE was used from 2009 and again in 2016 and 2020. Since 2022 the Bank has been reversing it by selling bonds back: quantitative tightening.

Think first

The Bank of England raises Bank Rate.

What usually happens to the value of the pound?

Higher UK interest rates make it more attractive to save money in the UK. Foreign savers buy pounds to do so, so demand for the pound rises and its value goes up. That makes UK exports dearer and imports cheaper.

Step by step

1. The economy is overheating. AD1 meets SRAS beyond LRAS: a positive output gap, with demand-pull inflation above target.

   Check: The UK inflation target is set by:

   The government sets the target; the Bank decides how to hit it.

2. Through all of these channels, AD shifts left to AD2. Real GDP falls back towards potential and the price level is lower than it would have been: inflation falls.

3. The <b>real interest rate</b> is the nominal rate minus inflation. With Bank Rate at 3.75% and inflation at 3.5% in September 2026, the real rate is only about 0.25%: what really matters for savers and borrowers.

   Check: A cut in Bank Rate is most likely to:

   Cheaper borrowing and less reward for saving raise C and I.

4. Summary: a rise in Bank Rate shifts AD left to bring inflation down; a cut shifts AD right to support growth and jobs. The Bank’s first aim is 2% inflation; subject to that, it supports the government’s aims for growth and jobs.

A common mistake

Higher UK interest rates attract savings from abroad, so demand for the pound rises and it appreciates. Exports become dearer, so net exports fall, which helps reduce AD.

Exam question

Explain how a rise in Bank Rate could reduce inflation.

Model answer

A rise in Bank Rate leads banks to raise their own interest rates.

Borrowing becomes more expensive and saving more rewarding, so households spend less and firms invest less. Households on variable-rate mortgages pay more each month, leaving less to spend. Higher rates also attract savings from abroad, so the pound appreciates: exports become dearer and imports cheaper, so net exports fall.

With C, I and net exports all lower, AD shifts to the left.

[Diagram: AD1 to AD2, with the equilibrium moving back from beyond LRAS to LRAS; the price level is lower.]

The positive output gap closes and demand-pull pressure eases, so inflation falls back towards the 2% target. Cheaper imports also lower prices directly.

However, the effect takes time, up to about two years, because many households are on fixed-rate mortgages and only feel the rise when their deal ends. If inflation is mainly cost-push, as in 2022, higher rates reduce output and jobs while doing little about the original cause.