Interest Rate Theories - Maintaining Interest! - Why do interest rates stay where they're set?

As we have seen the level of interest rates is set by the Monetary Policy Committee of the Bank of England. However, they cannot just announce a change in interest rates and leave it at that. It has to ensure that this level of interest rates is not undermined by changes in the demand for money or in the supply of money. In other words they have to intervene in the money markets to ensure that this new level of interest rates remains the equilibrium level.

They do this through their dealings with banks and other financial institutions. The Bank of England will usually try to ensure that the markets are kept a little short of liquidity. This will happen automatically if the amount of tax paid in a given day (taken out of bank accounts) is less than the banks receive that same day in government expenditure being paid into accounts held by them. Even if this is not the case, sales of government debt (Treasury Bills and gilt-edged securities) will leave the banks short of cash. This is because the people buying the debt will take the money out of their bank accounts to pay the government, leaving the banks with less money.

The banks being a bit short will turn to the Bank of England as 'Lender of Last Resort'. The Bank of England will provide the banks with the necessary liquidity (usually by 're-purchasing securities from them - a 'repo agreement') but at the interest rate they choose. This interest rate will be the interest rate they have set. In this way interest rates are maintained.