An Overview of Monetary Policy (DP IB Economics)

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
  

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 

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

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

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

Diagram Analysis

• The economy is initially in macroeconomic equilibrium AP₁Y_FE

• 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