Monetary Policy Measures (Cambridge (CIE) O Level Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Monetary Policy Defined
Monetary policy involves adjusting the money supply so as to influence total (aggregate) demand
The money supply is the amount of money in an economy at any given moment in time
It consists of coins, banknotes, bank deposits central bank reserves
The Central Bank in each economy is responsible for setting monetary policy
The Bank's Monetary Policy Committee usually meets 4-8 times a year to set policy
The three main instruments of monetary policy
Interest Rates: Incremental adjustments to the interest rate (usually not more than 0.25%)
Quantitative easing (QE): Increases the supply of money in the economy. The Central Bank creates new money and uses it to buy open-market assets such as bonds. When they buy the bond back early, there is an injection of new money into the economy (investors get their money back and can now spend it)
Exchange Rates: Adjustments to the exchange rate. The Central Bank is able to influence the exchange rate through buying or selling its own currency. This in turn influences the level of exports/imports
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
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
The Effects of Monetary Policy on Government Macroeconomic Aims
When a policy decision is made, it creates a ripple effect through the economy impacting the macroeconomic objectives of the government
To understand the effects of monetary policy on an economy, it is useful to know how total demand (gross domestic product) is calculated
Total (aggregate) demand = household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
Total demand = 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
Examples of the Impact of Contractionary Monetary Policy
Example 1 | The Central Bank increases interest rates |
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Effect on the economy |
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Impact on macroeconomic aims |
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Examples of the Impact of Expansionary Monetary Policy
Example 1 | The USA Federal Reserve Bank commits to $60bn a month of QE |
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Effect on the economy | Commercial banks receive cash for their bonds → liquidity in the market increases → commercial banks lower lending rates → consumers and firms borrow more → consumption and investment increase → total demand increases |
Impact on macroeconomic aims |
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Strengths of monetary policy
The Bank of England operates independently from the Government (political process)
Is able to consider the long-term outlook
Targets inflation and maintains stable prices
Depreciating the currency can increase exports
Weaknesses of monetary policy
Conflicting goals e.g. economic growth caused by lower rates puts upward pressure on inflation
Time lags between policy and the desired impact (up to 2 years)
Firms and consumers may not respond to lower interest rates when confidence is low
Cheaper loans may inflate asset prices (e.g. property) in the long term
The interest rate has limitations on downward adjustment - the closer the rate gets to zero, the less effective
Examiner Tips and Tricks
Remember that while a rise in the rate of interest is likely to increase saving by households, it is likely to reduce investment by firms
When evaluating 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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