The Impact of Monetary Policy on Macroeconomic Objectives (Edexcel IGCSE Economics)

Revision Note

Author

Steve Vorster

Expertise

Economics & Business Subject Lead

How Does Contractionary Monetary Policy Affect Macroeconomic Objectives?

When monetary policy decisions are made, it creates a ripple effect through the economy, impacting the macroeconomic objectives of the government
- Specifically, the use of monetary policy aims to achieve
  - A low and stable rate of inflation
  - Low unemployment
  - Reduce economic cycle fluctuations
  - Promote a stable economic environment for long-term growth
  - To influence the level of exports and imports

An example of contractionary monetary policy is if the Reserve Bank of Australia raises interest rates from 4% to 4.25%

Impact of Contractionary Monetary Policy on Macroeconomic Objectives

Macroeconomic Objective	Impact
Economic growth	Economic growth slows down as loans get more expensive Consumers and firms are less likely to borrow money. leading to a decrease in total demand
Low and stable inflation	Higher interest rates ease inflationary pressure as economic activity contracts However, borrowing may continue if consumer and business confidence are high
Low unemployment	Unemployment may increase as output is falling and fewer workers are required
Stable current account on balance of payments	The Current Account is likely to worsen as both exports and imports decrease Exports are more expensive and imports cheaper, but households have less income for imports

How Does Expansionary Monetary Policy Affect Macroeconomic Objectives?

An example of expansionary monetary policy is the extra €60 billion a month of QE released by the European Central Bank (ECB) during 2016
- This may increase economic growth but also create inflationary pressures

Impact of Expansionary Monetary Policy on Macroeconomic Objectives

Macroeconomic Objective	Impact
Economic growth	Economic activity increases as loans get cheaper There is an incentive to borrow money by consumers and firms This is used for consumption by households and investment by firms, leading to an increase in total demand
Low and stable inflation	Extra money supply may lead to rapid inflation As the supply of money increases, interest rates decrease and there is is more demand for loans This can inflate asset prices (houses) in the long term The interest rate has limitations on downward adjustment The closer it gets to zero, the less effective changes are
Low unemployment	Unemployment is likely to fall as a result of more consumer borrowing and spending Firms increase output to meet demand and more workers are required
Stable current account on balance of payments	Inflation causes higher price levels Higher price levels increase the price of exports, reducing foreign demand Demand for imports may increase as households have more money to purchase foreign goods

Examiner Tip

When analysing monetary policy, it is worth noting that monetary policy can be adjusted more frequently (4–8 times per year) 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 much interest rates fall.

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