Monetary Policy Measures (Cambridge (CIE) O Level Economics)

Revision Note

Written by: Steve Vorster, Economics & Business Subject Lead

Reviewed by: Jenna Quinn, Head of New Subjects

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
Effect on the economy	Existing loan repayments for households become more expensive → discretionary income reduces → consumption decreases → total demand falls Firms are less likely to borrow → less investment in capital takes place → total demand falls Hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → total demand decreases
Impact on macroeconomic aims	Economic growth slows down Inflation eases Unemployment may increase as output is falling and fewer workers are required Current Account is likely to worsen as both exports and imports reduce (exports more expensive and imports cheaper - but households have less income for imports)

Example 1

The Central Bank increases interest rates

Effect on the economy

Existing loan repayments for households become more expensive → discretionary income reduces → consumption decreases → total demand falls
Firms are less likely to borrow → less investment in capital takes place → total demand falls
Hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → total demand decreases

Impact on macroeconomic aims

Economic growth slows down
Inflation eases
Unemployment may increase as output is falling and fewer workers are required
Current Account is likely to worsen as both exports and imports reduce (exports more expensive and imports cheaper - but households have less income for imports)

Examples of the Impact of Expansionary Monetary Policy

Example 1	The USA Federal Reserve Bank commits to $60bn a month of QE
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	Economic growth increases Inflation rises Unemployment may fall as output is increasing and more workers are required Current Account worsens (with more income, imports may rise)

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 Tip

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.

Last updated: 18 June 2024

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