Over the short term, moreover, the actual equilibrium interest rate, r*, will fluctuate around the trend level, R*, driven by shorter-term influences from both demand and supply. This is what matters for monetary policy here and now. Why? Because r* is the rate at which demand is in line with supply so that there is no output gap – neither excess demand nor excess supply in the economy. Responding to shifts in r* is what helps keep inflation close to target. This does not mean that monetary policy should always align Bank Rate exactly to r*. Sometimes, monetary policy faces trade-offs between inflation and the balance of supply and demand. But it does mean that supply matters for monetary policy also in the short run. By determining the level of demand the economy can sustain without generating excess  Bank of England  Page 10  inflationary pressures, it affects the appropriate level of interest rates, effectively by setting the speed limit for the economy. And when shocks drive inflation away from target in the way we have seen, monetary policy responds by steering demand to a level – relative to supply – that ensures that inflation returns to target sustainably. Monetary policy cannot affect this level of supply. But the level of supply will affect the appropriate setting of monetary policy. It matters, therefore, that big shocks to the economy have weighed heavily on supply in recent times.
And sometimes shifts in supply can be as abrupt and as important for the inflation outlook as shifts in demand. We have seen this very clearly in the past three years since Covid hit. Throughout this time, the Monetary Policy Committee has had to play close attention to the supply side of the economy – and make a number of critical judgements about it – for instance, as care for the public’s health necessitated a pause in a range of economic activities. That is the reason I would like to focus on supply in my remarks here this evening. Supply, R* and monetary policy I will start by making a distinction between the short run and the long run. Monetary policy’s inability to influence supply has at times been taken to suggest that monetary policy has no effects on real economic activity at all. In classical economic theory, for example, monetary policy only affects nominal variables such as wages and prices, not real variables such as the level of production and employment. In this tradition, real business cycle theories have been developed in which supply side disturbances are the main drivers of real activity. But overwhelming empirical evidence, and many years of practical experience, show that monetary policy affects economic activity and inflation through aggregate demand. In the New Keynesian models that have dominated monetary macroeconomics over the past  Bank of England  Page 4  three decades, monetary policy has real effects because market prices are sticky.