Revision NotesPast Papers
IBEconomicsDPSLRevision Notes3. Macroeconomics3.5 Demand Management: Monetary Policy3.5.1 An Overview of Monetary Policy

An Overview of Monetary Policy (DP IB Economics)

Revision Note

Last updated

DP Economics: SLDP Economics: HL

Introduction to Demand-side Policies

  • Demand-side policies aim to shift aggregate demand (AD) in an economy 

  • There are two categories of demand-side policies

    • Fiscal policy and monetary policy

  • Fiscal policy involves the use of government spending and taxation to influence AD

    • The government is responsible for setting fiscal policy

    • Governments usually present their fiscal policies to the country each year when they deliver the Government budget

  • Monetary policy involves adjusting interest rates and the money supply so as to influence AD

    • Central Banks are usually responsible for setting monetary policy

    • Central Bank committees usually meet 4-8 times a year to set policy

The Goals of Monetary Policy

  • Monetary policy is used to help the government achieve their macroeconomic objectives

  • Specifically, the use of monetary policy aims to achieve

    • A low and stable rate of inflation

    • Low unemployment

    • Reduce business cycle fluctuations

    • Promote a stable economic environment for long-term growth

    • To control the level of exports and imports (net external balance)

  • When a policy decision is made, it creates a ripple effect through the economy impacting the macroeconomic objectives of the government

Real Versus Nominal Interest Rates

  • In economics, the use of the word nominal refers to the fact that the metric has not been adjusted for inflation 

  • The nominal interest rate is the headline rate presented by commercial banks

    • There has been no adjustment to the interest rate based on the rate of inflation

  • The real interest rate is the nominal interest rate minus the rate of inflation

    • For example, if the nominal interest rate for saving money at a commercial bank is 3% and inflation is 2% then the real interest rate is 1%

    • The value of the savings is effectively increasing by only 1%
       

  • The real interest rate can also be calculated using consumer price index (CPI) data

Worked Example

Using the data, calculate the real interest rate in 2021  [3 marks]

Year

CPI

Nominal Interest rate

2020

103.2

-

2021

105.9

4%


Answer:

Step 1: Calculate the inflation rate by calculating the % difference between the CPI for 2021 and 2020

 Inflation space rate space equals space fraction numerator New space CPI space minus space Old space CPI over denominator Old space CPI end fraction space straight x space 100 Inflation space rate space equals space fraction numerator 105.9 space minus space 103.2 over denominator 103.2 end fraction space straight x space 100 Inflation space Rate equals space 2.62 percent sign

Step 2: Calculate the real interest rate

Real interest rate = nominal interest rate - inflation rate

          = 4% - 2.62%

                = 1.38%
 

(3 marks for a correct answer or 1 mark for any correct working)

Expansionary & Contractionary Monetary Policy

Expansionary Monetary Policy

  • Monetary policy can be expansionary in order to generate further economic growth (also referred to as loose monetary policy)

    • Expansionary policies include reducing interest rates, increasing QE, or depreciating the exchange rate 
         

  • To understand the effects of monetary policy on an economy, it is useful to know how aggregate demand (AD) is calculated

    • AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)

    • AD = C + I + G + (X - M)
       

  • From this, it is logical that changes to monetary policy can influence any of these components - and often several of them at once  

  • Expansionary monetary policy aims to shift aggregate demand (AD) to the right 

2-4-3---changes-to--equilibrium---classical-increase-in-ad

Classical diagram illustrating expansionary monetary policy which increases real GDP (Y1 →Y2) and average price levels (AP1 →AP2) 

Diagram Analysis

  • The economy is initially in macroeconomic equilibrium AP1Y1

  • The Central Bank is wanting to boost economic growth and lowers interest rates

  • Lower interest rates cause investment and consumption to increase which are components of AD

  • Aggregate demand increases from AD1→ AD2

  • The economy reaches a new equilibrium at AP2Y2 - a higher average price level and a greater level of national output

An Example of how Expansionary Monetary Policy Impacts on the Goals


The USA Federal Reserve Bank commits to an extra $60bn a month of QE

Effect on the economy

  • Commercial banks receive cash for their bonds → liquidity in the market increases → commercial banks lower lending rates → consumers and firms borrow more → consumption and investment increase → AD increases 

Impact on macroeconomic aims

  • Economic growth increases

  • Inflation rises

  • Unemployment may fall as output is increasing and more workers are required

  • Net external demand worsens (with higher price levels exports may decrease and with rising incomes, imports may increase)

Contractionary Monetary Policy

  • Monetary policy can be contractionary in order to slow down economic growth or reduce inflation (also referred to as tight monetary policy)

    • Contractionary policies include increasing interest rates, decreasing/stopping QE, or appreciating the exchange rate
        

  • Contractionary monetary policy aims to shift aggregate demand to the left

2-6-2-contractionary-demand-side-policies

Keynesian diagram illustrating contractionary monetary policy which decreases the real GDP (YFE →Y1) and average price levels (AP1 →AP2)
 

Diagram Analysis

  • The economy is initially in macroeconomic equilibrium AP1YFE

  • The Central Bank is wanting to lower inflation towards its target of 2% - and increases interest rates

  • Higher interest rates cause investment and consumption to decrease

  • Aggregate demand decreases from AD1→ AD2

  • The economy reaches a new equilibrium at AP2Y1 - a lower average price level and a smaller level of national output

  An Example of how Contractionary Monetary Policy Impacts on the Goals

The Central Bank increases interest rates

Effect on the economy

  • Existing loan repayments for households become more expensive → discretionary income reduces → consumption decreases → total demand falls

  • Firms are less likely to borrow  → less investment in capital takes place → AD falls

  • Hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases

Impact on macroeconomic aims

  • Economic growth slows down

  • Inflation eases

  • Unemployment may increase as output is falling and fewer workers are required

  • Net external demand is likely to worsen as both exports and imports reduce (exports more expensive due to higher exchange rate and imports cheaper - but households have less income for imports)

Examiner Tips and Tricks

When analysing monetary policy, it is worth noting that monetary policy (4-8 x per year) can be adjusted more quickly than fiscal policy (usually once per year). However, the impact of fiscal policy is more predictable than the impact of monetary policy. For example, households may not borrow more money if their confidence in the economy is low - irrespective of how low interest rates go.

You've read 0 of your 5 free revision notes this week

Sign up now. It’s free!

Join the 100,000+ Students that ❤️ Save My Exams

the (exam) results speak for themselves:

    Did this page help you?

    Previous:3.4.4 Other Policies to Reduce Inequality & PovertyNext:3.5.2 The Effectiveness Of Monetary Policy