Monetary Policy Transmission Mechanisms (AQA A Level Economics)

Monetary Policy Actions

• The Central Bank has several policy actions available to use

• Depending on the severity of the economic conditions faced, they can choose to make changes to several if required

Monetary Policy Actions

The Factors Considered by the MPC When Setting the Bank Rate

• The MPC considers how the economy is performing when adjusting the bank rate

• Their main goal is to achieve price stability

• They also consider the stage of the trade cycle and support government in achieving their macroeconomic objectives 

Factors to Consider when Setting the Bank Rate

Monetary Policy Transmission Mechanisms

• The two main instruments of monetary policy include: 

  • Incremental adjustments to the interest rate (usually not more than 0.25%)

  • Quantitative easing which increases the supply of money in the economy

    • The Central Bank creates new money and uses it to buy open-market assets

• When a policy decision is made, it creates a ripple effect through the economy and this effect is known as a transmission mechanism

Diagram: Incremental Changes to Interest Rates

Before Explaining a Mechanism from the Diagram Above, Key Terminology Can Be Reviewed Below

Example 1

• Official rate decreases by 0.25% → market rates decrease → loans are cheaper → consumers borrow more → consumption increases → AD increases → inflation increases

Example 2

• Official rate decreases by 0.25% → market rates decrease → mortgages are cheaper → property buyers borrow more → demand for houses increases → asset prices increase 

Example 3

• Official rate decreases by 0.25% → market rates decrease → buyers borrow more → asset prices increase → households with assets feel wealthier → consumption increases → AD increases → inflation increases

Example 4

• Official rate increases by 0.25% → hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases → inflation decreases

Example 5

• Official rate increases by 0.25% → market rates increase → existing loan repayments now more expensive to repay → discretionary income falls → consumption decreases → AD decreases → inflation decreases

The transmission impact on exchange rates

• A change to the bank rate will have an impact on the exchange rate

  • When the exchange rate changes, there will be a ripple effect through the economy

  • This can be seen in the diagram above, where a change to the exchange rate leads to changes in the net external demand as well as the import prices 

How Interest Rates Impact Exchange Rates

Using Interest Rates to Lower Inflation

Is inflation too high? Increase the interest rates                     

• If the MPC wants to lower inflation, it will increase the interest rate

• This lower rate aims to reduce aggregate demand and control inflation

• Contractionary monetary policy will shift aggregate demand to the left

• The Bank of England cut the Bank Rate nine times between December 2007 & March 2009 dropping from 5.75% to 0.5%

Diagram: Keynesian Contractionary Demand-side Policies

Diagram analysis 

• Contractionary monetary policy will shift aggregate demand to the left (AD₁ →AD₂)

• AD shifts to the left because a higher interest rate impacts the components: Consumption (C ), Investment (I) and Exports and Imports (X − M) via the exchange rate

Consumption

• With the rise in interest rates, consumption declines as household borrowing is discouraged and savings are encouraged (C)

• The increase in interest rates on mortgages results in decreased disposable income for households

• Consumers now have less income and tend to spend less, leading to a notable decrease in aggregate demand (AD₁ →AD₂)

• This fall in aggregate demand contributes to a reduction in real GDP (Y_FE → Y₁) and average price levels (AP₁ → AP₂)

Investment 

• Investment falls as businesses borrow less due to higher interest rates

• Higher borrowing costs serve as a disincentive for businesses to undertake new investment projects

  • This reduction in business investment leads to a decline in aggregate demand in the UK economy (AD1 →AD2)

  • The contraction in aggregate demand results in a reduction in real GDP from its potential level (Y_FE) to a lower level (Y₁)

  • Additionally, the weakened demand contributes to a decrease in average price levels, transitioning from AP₁ → AP₂

Net Exports 

• A higher interest rate increases demand for the UK pound, as it offers a better return on investment, increasing capital flows into the currency

• The increased demand for the pound causes the exchange rate to rise. As a result:

  • Exports become relatively more expensive and less competitive in the global market

  • Imports become relatively cheaper and more competitive in the UK markets.

  • This worsens the UK's Balance of Payment on the current account.

• Aggregate Demand (AD) shifts to the left as a result of these economic changes, reflecting reduced overall spending in the economy

Using Interest Rates to Increase Inflation

Is inflation too low? Decrease the interest rates

• If the MPC wants to encourage borrowing, it will decrease the interest rate

• This lower rate aims to stimulate aggregate demand

• This type of policy is known as a demand-side expansionary policy 

Diagram: Expansionary Demand-side Policies 

• Expansionary Monetary Policy will shift aggregate demand to the right (AD₂ → AD₁):

• AD Shifts to the right because lower Interest Rates Impact the Components: Consumption (C), Investment (I), and Exports and Imports (X − M) via the Exchange Rate:

Consumption

• Lower interest rates stimulate consumption as households have more disposable income.

• Increased consumer spending contributes to a rise in aggregate demand (AD₂ → AD₁)

• This increase in aggregate demand leads to an expansion in real GDP (Y₁ → Y_FE) and average price levels (AP₂ → AP₁)

Investment

• Lower interest rates make borrowing more attractive for businesses, encouraging new investment projects

  • The increase in business investment contributes to an increase in aggregate demand (AD₂ → AD₁)

  • This expansion in aggregate demand results in an increase in real GDP from its potential level (Y_FE) to a higher level (Y₁)

• Additionally, the heightened demand contributes to an increase in average price levels, transitioning from (AP₂ → AP₁)

Net Exports

• A lower interest rate reduces demand for the UK pound, as it offers a lower return on investment, leading to decreased capital flows into the currency

• The decreased demand for the pound causes the exchange rate to fall. As a result:

  • Exports become relatively cheaper and more competitive in the global market.

  • Imports become relatively more expensive and less competitive in the UK markets.

  • This improves the UK's Balance of Payment on the current account

• Aggregate Demand (AD) shifts to the right as a result of these economic changes, reflecting increased overall spending in the economy (AD₂ → AD₁)