Types of Monetary Policy (Edexcel IGCSE Economics)

The Mechanisms of Monetary Policy

• The two main tools of monetary policy include:

  • The adjustment of interest rates by the Central Bank

  • Asset purchasing by the Central Bank through a mechanism called quantitative easing

• Monetary policy can be expansionary or contractionary:

  • Expansionary monetary policy can be used to generate economic growth (also referred to as loosening monetary policy)

    • Expansionary policies include reducing interest rates and increasing quantitative easing

  • Contractionary monetary policy can be used to slow down economic growth or reduce inflation (also referred to as tight monetary policy)

    • Contractionary policies include increasing interest rates and decreasing/stopping quantitative easing

Interest Rates Changes

• To address the persistent challenge of high levels of inflation seen during 2022–2024, most central banks around the world have opted to increase interest rates

Source: Tradingview

Graph analysis

• In the period 2020–21, the interest rate fell to almost 0% for UK and South Korea

  • This loosening of monetary policy was in response to COVID-19 pandemic, to encourage borrowing and stimulate economic growth

• In the period 2021–24, high levels of inflation was experienced by countries around the world

  • This was partly due to cost-push inflation as the pandemic and geopolitical tensions in Russia and Ukraine caused global supply chain disruptions

  • The increased government spending (expansionary fiscal policy) during the pandemic caused some demand-pull inflation 

• Overall interest rates for Mexico, South Korea, the United Kingdom, and South Africa have risen for the period 2021-2024

  • Mexico saw the highest rates of 11% in 2023

The impact of increasing the interest rate

• The impact is different for different consumers and businesses

Explaining the Impact of Higher Interest Rates

The impact of decreasing the interest rate

• When the Central Bank decreases the base rate, commercial banks usually lower their savings and borrowing rates

Explaining the Impact of a Lower Interest Rate

Quantitative Easing

• Quantitative easing (QE) is a monetary policy tool used by Central Banks to stimulate the economy

  • When traditional monetary policy measures, such as interest rate cuts, have become less effective, QE is another mechanism that can be effective in generating economic growth

  • This was used by many countries after the 2008 financial crisis and during the Covid pandemic of 2020-2022

• QE is also known as central bank asset purchases

• The primary objective of QE is to increase the amount of money available in an economy, which lowers long-term interest rates and encourages lending and investment to stimulate economic activity

  • It aims to address issues like low inflation, deflationary pressures, and stagnant economic growth 

Diagram: Quantitative Easing

How does QE work?

• The Central Bank creates new electronic reserves (digital money)

• It then buys back previously issued government bonds from commercial banks, financial institutions and households (asset purchase)

• Banks, financial institutions and households now have more money

• These increased balances can lead to a higher capacity for commercial banks to lend to firms

• Interest rates generally decline due to the added availability of money

• Borrowing increases and total demand is stimulated through investment and consumption

Example: QE in the USA

• The USA Federal Reserve Bank boosted the money supply by $600 billion after the 2008-2012 recession . This led to:

  • Increased liquidity (avaliable money) as the Federal Reserve injected money

  • Banks had extra money to lend, so there were lower interest rates available on loans

    • With cheaper loans, households could borrow more money

      • Consumers spent more on goods and services, and businesses invested more

    • With cheaper loans, businesses could borrow more money and increase their investment

      • With increased spending and investment, the overall demand for goods and services in the economy increased, leading to economic growth