Types of Monetary Policy (Edexcel IGCSE Economics)

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Steve Vorster

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Economics & Business Subject Lead

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

**Mexico, South Africa, United Kingdom and South Korea have seen increases in interest rates from 2021 to 2024**

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

Impact	Explanation
Consumers	Existing loan repayments (such as mortgages on houses, bank loans and credit cards) for households become more expensive as interest rates rise Discretionary income reduces and consumption decreases The total demand in the economy falls
Businesses	Higher interest rates act as a disincentive for businesses to borrow, and existing loan repayments become more expensive This results in less capital investment taking place Slower rates of economic growth result

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

Impact	Explanation
Consumers	Existing loan repayments (such as mortgages on houses, bank loans and credit cards) for households become less expensive as interest rates fall Cheaper borrowing incentivises household spending on expensive goods and services, such as cars, holidays, and property. This increases economic activity During the COVID-19 pandemic, central banks worldwide reduced interest rates to near 0% in an attempt to stimulate household spending, although this was not very successful due to low consumer confidence
Businesses	Lower interest rates encourage firms to increase their borrowing Loans are used to finance capital investments such as expanding operations and buying more machinery Despite interest rates falling to near 0%, some businesses remained reluctant to borrow in 2020-2022 mostly due to a lack of business confidence

Impact

Explanation

Consumers

Existing loan repayments (such as mortgages on houses, bank loans and credit cards) for households become less expensive as interest rates fall
Cheaper borrowing incentivises household spending on expensive goods and services, such as cars, holidays, and property. This increases economic activity
During the COVID-19 pandemic, central banks worldwide reduced interest rates to near 0% in an attempt to stimulate household spending, although this was not very successful due to low consumer confidence

Businesses

Lower interest rates encourage firms to increase their borrowing
Loans are used to finance capital investments such as expanding operations and buying more machinery
Despite interest rates falling to near 0%, some businesses remained reluctant to borrow in 2020-2022 mostly due to a lack of business confidence

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

**The QE process as an expansionary monetary policy**

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

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