An Overview of Monetary Policy (DP IB Economics)
Revision Note
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
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
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
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Effect on the economy |
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Impact on macroeconomic aims |
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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 (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 |
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Impact on macroeconomic aims |
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Examiner Tip
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.
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