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Home / IB / Economics / SL / Revision Notes / 3. Macroeconomics / 3.5 Demand Management: Monetary Policy / 3.5.1 An Overview of Monetary Policy


3.5.1 An Overview of Monetary Policy


Introduction to Demand-side Policies

  • Demand-side policies aim to shift aggregate demand (AD) in an economy
     
  • There are two categories of demand-side policies
    • Fiscal policy and monetary policy

  • Fiscal policy involves the use of government spending and taxation to influence AD
    • The government is responsible for setting fiscal policy
    • Governments usually present their fiscal policies to the country each year when they deliver the Government budget

  • Monetary policy involves adjusting interest rates and the money supply so as to influence AD
    • Central Banks are usually responsible for setting monetary policy
    • Central Bank committees usually meet 4-8 times a year to set policy

The Goals of Monetary Policy

  • Monetary policy is used to help the government achieve their macroeconomic objectives
  • Specifically, the use of monetary policy aims to achieve
    • A low and stable rate of inflation
    • Low unemployment
    • Reduce business cycle fluctuations
    • Promote a stable economic environment for long-term growth
    • To control the level of exports and imports (net external balance)
  • When a policy decision is made, it creates a ripple effect through the economy impacting the macroeconomic objectives of the government

Real Versus Nominal Interest Rates

  • In economics, the use of the word nominal refers to the fact that the metric has not been adjusted for inflation
     
  • The nominal interest rate is the headline rate presented by commercial banks
    • There has been no adjustment to the interest rate based on the rate of inflation

  • The real interest rate is the nominal interest rate minus the rate of inflation
    • For example, if the nominal interest rate for saving money at a commercial bank is 3% and inflation is 2% then the real interest rate is 1%
    • The value of the savings is effectively increasing by only 1%
       
  • The real interest rate can also be calculated using consumer price index (CPI) data

Worked Example

Using the data, calculate the real interest rate in 2021  [3 marks]

Year CPI Nominal Interest rate
2020 103.2 -
2021 105.9 4%

Step 1: Calculate the inflation rate by calculating the % difference between the CPI for 2021 and 2020

Inflation space rate space equals space fraction numerator New space CPI space minus space Old space CPI over denominator Old space CPI end fraction space straight x space 100

Inflation space rate space equals space fraction numerator 105.9 space minus space 103.2 over denominator 103.2 end fraction space straight x space 100

Inflation space Rate equals space 2.62 percent sign

 

Step 2: Calculate the real interest rate

Real interest rate = nominal interest rate - inflation rate

          = 4% - 2.62%

                = 1.38%
 

(3 marks for a correct answer or 1 mark for any correct working)

Monetary Policy Instruments

  • The two main instruments of monetary policy include
    • Incremental adjustments to the interest rate (usually not more than 0.25%)
    • Quantitative easing which 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 a policy decision is made, it creates a ripple effect through the economy and this effect is known as a transmission mechanism
     

Incremental Changes to Interest Rates

 

2-6-2-transmission-mechanisms

The transmission mechanisms of changes to the interest rate


Before Explaining a Mechanism from the Diagram Above, key Terminology can be Reviewed Below

Official Rate Market Rates Asset Prices
Exchange Rate Net External Demand Inflation

  

Example 1

  • Official rate decreases by 0.25% → market rates decrease → loans are cheaper → consumers borrow more → consumption increases → AD increases → inflation increases

Example 2

  • Official rate decreases by 0.25% → market rates decrease → mortgages are cheaper → property buyers borrow more → demand for houses increases → asset prices increase 

Example 3

  • Official rate decreases by 0.25% → market rates decrease → buyers borrow more → asset prices increase → households with assets feel wealthier → consumption increases → AD increases → inflation increases

Example 4

  • Official rate increases by 0.25% → hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases → inflation decreases

Example 5

  • Official rate increases by 0.25% → market rates increase → existing loan repayments now more expensive to repay → discretionary income falls → consumption decreases → AD decreases → inflation decreases

 
Quantitative Easing Transmission Mechanism

  • The Bank of England commits to buy £60bn of gilts a month → commercial banks receive cash for their gilts → liquidity in the market increases → commercial banks lower lending rates → consumers and firms borrow more → consumption and investment increase → AD increases → inflation increases

Expansionary & Contractionary Monetary Policy

Expansionary Monetary Policy

  • 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 
         
  • To understand the effects of monetary policy on an economy, it is useful to know how aggregate demand (AD) is calculated
    • AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
    • AD = 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
      
  • Expansionary monetary policy aims to shift aggregate demand (AD) to the right
     

2-4-3---changes-to--equilibrium---classical-increase-in-ad

Classical diagram illustrating expansionary monetary policy which increases real GDP (Y1 →Y2) and average price levels (AP1 →AP2)
 

Diagram Analysis

  • The economy is initially in macroeconomic equilibrium AP1Y1
  • The Central Bank is wanting to boost economic growth and lowers interest rates
  • Lower interest rates cause investment and consumption to increase which are components of AD
  • Aggregate demand increases from AD1→ AD2
  • The economy reaches a new equilibrium at AP2Y2 - a higher average price level and a greater level of national output

An Example of how Expansionary Monetary Policy Impacts on the Goals


The USA Federal Reserve Bank commits to an extra $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 → AD increases 

Impact on macroeconomic aims

  • Economic growth increases
  • Inflation rises
  • Unemployment may fall as output is increasing and more workers are required
  • Net external demand worsens (with higher price levels exports may decrease and with rising incomes, imports may increase)

   

Contractionary Monetary Policy

  • 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
        
  • Contractionary monetary policy aims to shift aggregate demand to the left

2-6-2-contractionary-demand-side-policies

Keynesian diagram illustrating contractionary monetary policy which decreases the real GDP (YFE →Y1) and average price levels (AP1 →AP2)
 

Diagram Analysis

  • The economy is initially in macroeconomic equilibrium AP1YFE
  • The Central Bank is wanting to lower inflation towards its target of 2% - and increases interest rates
  • Higher interest rates cause investment and consumption to decrease
  • Aggregate demand decreases from AD1→ AD2
  • The economy reaches a new equilibrium at AP2Y1 - a lower average price level and a smaller level of national output

  

An Example of how Contractionary Monetary Policy Impacts on the Goals


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 → AD falls
  • Hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases

Impact on macroeconomic aims

  • Economic growth slows down
  • Inflation eases
  • Unemployment may increase as output is falling and fewer workers are required
  • Net external demand is likely to worsen as both exports and imports reduce (exports more expensive due to higher exchange rate and imports cheaper - but households have less income for imports)

   

Exam Tip

When analysing 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.

An Evaluation of Monetary Policy

Strengths of Monetary Policy

  • Central Banks can operate independently from the Government (political process)
    • Central Banks can consider the long-term outlook
  • Contractionary policy is often effective when there is an inflationary gap
    • Targets inflation and maintains stable prices
  • Depreciating the currency can increase exports
  • The frequency of policy alterations (4-8 times per year) allows for constant adjustments to macroeconomic variables


Weaknesses of Monetary Policy

  • Conflicting goals e.g economic growth puts upward pressure on inflation
  • Expansionary policy is less effective during a deflationary gap
    • The larger the output gap the less effective it can be 
    • Consumers may not respond to lower interest rates when confidence is low
  • Time lags between policy and the desired impact (up to 2 years)
    • During particularly bad recessions, the impact of expansionary policy may take some time to be seen in the economy
  • Expansionary policy leads to cheaper credit which 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


  • 1. Introduction To Economics
    • 1.1 What Is Economics?
      • 1.1.1 Economics as a Social Science
        • 1.1.2 The Problem of Choice
          • 1.1.3 The Production Possibilities Curve Model (PPC)
            • 1.1.4 Modelling the Economy
            • 1.2 How Do Economists Approach The World?
              • 1.2.1 Economic Methodology
                • 1.2.2 Economic Thought
              • 2. Microeconomics
                • 2.1 Demand
                  • 2.1.1 Demand, Price & Quantity
                    • 2.1.2 Non-Price Determinants of Demand
                    • 2.2 Supply
                      • 2.2.1 Supply, Price & Quantity
                        • 2.2.2 Non-Price Determinants of Supply
                        • 2.3 Competitive Market Equilibrium
                          • 2.3.1 Market Equilibrium & Disequilibrium
                            • 2.3.2 Functions of the Price Mechanism
                              • 2.3.3 Consumer & Producer Surplus
                              • 2.4 Price Elasticity of Demand (PED)
                                • 2.4.1 Definition, Calculation & Determinants of PED
                                  • 2.4.2 The Significance of PED
                                  • 2.5 Income Elasticity of Demand (YED)
                                    • 2.5.1 Definition, Calculation & Illustration of YED
                                    • 2.6 Price Elasticity of Supply (PES)
                                      • 2.6.1 Definition, Calculation & Determinants of PES
                                      • 2.7 Role of Government In Microeconomics
                                        • 2.7.1 Reasons For Government Intervention In Markets
                                          • 2.7.2 Government Intervention: Indirect Taxes & Subsidies
                                            • 2.7.3 Government Intervention: Price Controls, Direct Provision & Regulation
                                            • 2.8 Market Failure: Externalities & Common Pool (Access) Resources
                                              • 2.8.1 Market Failure
                                                • 2.8.2 Negative Externalities
                                                  • 2.8.3 Positive Externalities
                                                    • 2.8.4 Common Pool (Access) Resources
                                                      • 2.8.5 Government Intervention to Address the Market Failure
                                                        • 2.8.6 Other Interventions to Address the Market Failure
                                                        • 2.9 Market Failure: Public Goods
                                                          • 2.9.1 Public Goods
                                                        • 3. Macroeconomics
                                                          • 3.1 Measuring Economic Activity
                                                            • 3.1.1 National Income & The Circular Flow of Income
                                                              • 3.1.2 National Income Terminology & Calculations
                                                                • 3.1.3 The Business Cycle
                                                                  • 3.1.4 Appropriateness of Using GDP/GNI to Measure Well-being
                                                                    • 3.1.5 Alternative Measures of Well-Being
                                                                    • 3.2 Variations in Economic Activity (AD & AS)
                                                                      • 3.2.1 Aggregate Demand (AD)
                                                                        • 3.2.2 Short-Run Aggregate Supply (SRAS)
                                                                          • 3.2.3 Alternative Views of Aggregate Supply (AS)
                                                                            • 3.2.4 Shifts of the Long-Run Aggregate Supply (LRAS)
                                                                              • 3.2.5 Macroeconomic Equilibrium
                                                                              • 3.3 Macroeconomic Objectives
                                                                                • 3.3.1 An Introduction to Macroeconomic Objectives
                                                                                  • 3.3.2 Economic Growth
                                                                                    • 3.3.3 Low Unemployment
                                                                                      • 3.3.4 Low & Stable Rate of Inflation
                                                                                        • 3.3.5 Potential Conflicts Between Macroeconomic Objectives
                                                                                        • 3.4 Inequality & Poverty
                                                                                          • 3.4.1 Measuring Inequality & Poverty
                                                                                            • 3.4.2 Causes of Inequality & Poverty
                                                                                              • 3.4.3 Using Taxation to Reduce Inequality & Poverty
                                                                                                • 3.4.4 Other Policies to Reduce Inequality & Poverty
                                                                                                • 3.5 Demand Management: Monetary Policy
                                                                                                  • 3.5.1 An Overview of Monetary Policy
                                                                                                  • 3.6 Demand Management: Fiscal Policy
                                                                                                    • 3.6.1 An Overview of Fiscal Policy
                                                                                                    • 3.7 Supply-Side Policies
                                                                                                      • 3.7.1 An Overview of Supply-Side Policies
                                                                                                        • 3.7.2 The Effectiveness of Supply-Side Policies
                                                                                                      • 4. The Global Economy
                                                                                                        • 4.1 Benefits of International Trade
                                                                                                          • 4.1.1 The Advantages of Free Trade
                                                                                                          • 4.2 Types of Trade Protection
                                                                                                            • 4.2.1 Tariffs
                                                                                                              • 4.2.2 Quotas
                                                                                                                • 4.2.3 Export Subsidies
                                                                                                                  • 4.2.4 Administrative Barriers
                                                                                                                  • 4.3 Arguments For & Against Trade Protection
                                                                                                                    • 4.3.1 Arguments For & Against Trade Protection
                                                                                                                    • 4.4 Economic Integration
                                                                                                                      • 4.4.1 Understanding Economic Integration
                                                                                                                        • 4.4.2 Types of Trading Blocs
                                                                                                                          • 4.4.3 The World Trade Organisation (WTO)
                                                                                                                          • 4.5 Exchange Rates
                                                                                                                            • 4.5.1 Types of Exchange Rate Systems
                                                                                                                              • 4.5.2 Causes & Consequences of Exchange Rate Fluctuations
                                                                                                                              • 4.6 Balance of Payments
                                                                                                                                • 4.6.1 Components of the Balance of Payments
                                                                                                                                • 4.7 Sustainable Development
                                                                                                                                  • 4.7.1 The Sustainable Development Goals
                                                                                                                                  • 4.8 Measuring Economic Development
                                                                                                                                    • 4.8.1 Single Indicators of Development
                                                                                                                                      • 4.8.2 Composite Indicators of Development
                                                                                                                                        • 4.8.3 Evaluating the Different Approaches
                                                                                                                                        • 4.9 Barriers to Economic Growth & Development
                                                                                                                                          • 4.9.1 Poverty Traps
                                                                                                                                            • 4.9.2 Economic, Political & Social Barriers
                                                                                                                                            • 4.10 Economic Growth & Development Strategies
                                                                                                                                              • 4.10.1 Trade Strategies, Diversification & Social Enterprise
                                                                                                                                                • 4.10.2 Market-Based & Interventionist Policies
                                                                                                                                                  • 4.10.3 Merit Goods & Inward Foreign Direct Investment
                                                                                                                                                    • 4.10.4 Foreign Aid & Development Assistance
                                                                                                                                                      • 4.10.5 Institutional Change
                                                                                                                                                        • 4.10.6 Evaluating Market Orientated Approaches Versus Government Intervention
                                                                                                                                                          • 4.10.7 Progress Towards Sustainable Development Goals

                                                                                                                                                        Author: Steve



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