[2.1.2] Economics - Monetary Policy

What is monetary policy?

Monetary policy involves changes to the interest rates and the money supply by the central bank in order to influence demand.

What is expansionary monetary policy?

Monetary policy that aims to increase demand through cutting interest rates and raising money supply.

What is the impact of expansionary monetary policy on inflation?

- when interest rates fall, the level of borrowing is likely to increase as the reward for saving and cost of borrowing decrease

- this is likely to increase consumer spending as the money supply increases, leading to an increase in demand

- this raises inflation by putting demand-pull inflationary pressure on the economy

What is the impact of expansionary monetary policy on unemployment?

- it will help to combat unemployment

- if interest rates fall, there is an increase in demand for loans, causing an increase in spending by firms and households

- this increases aggregate demand and firms respond by producing more goods and services

- this means that firms need to hire more staff, unemployment will thus fall

What is the impact of expansionary monetary policy on economic growth?

- expansionary monetary policy will increase economic growth

- as the cost of borrowing decreases, more consumers are more likely to spend

- as a result, firms are going to increase their level of output, causing the GDP to rise, and thus economic growth in turn

- moreover, through increased confidence, households will spend more and firms will expand production and invest more leading to stronger economic growth

What is the effect of expansionary monetary policy on the current account?

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- it will worsen the current account towards a deficit

- as consumers spend more due to a reduction in interest rates, demand increases within an economy

- this means the demand for imports also increases, causing the current account to worsen towards a deficit as we spend more on imports

What is contractionary monetary policy?

Contractionary monetary policy aims to decrease demand within an economy by raising the interest rates and decreasing money supply.

What is the effect of contractionary monetary policy on inflation?

- it will reduce inflation

- an increase in the interest rates means an increase in the reward for saving, which encourages more people to save their money

- this leads to less consumer spending

- this leads to reduced demand, so the demand curve shifts to the left and the price pressure (demand-pull) in an economy is alleviated

What is the effect of contractionary monetary policy on unemployment?

- unemployment could worsen

- as interest rates rise, there is a decrease in demand for loans and more people will save

- this reduces consumer and business spending

- firms respond by producing less goods and services, and less labour is needed to do so

- thus firms will hire less people and unemployment could increase

What is the impact of contractionary monetary policy on economic growth?

- contractionary monetary policy will reduce economic growth

- as interest rates increase, the cost of borrowing increases

- this leads to less consumer spending, meaning firms will produce less, GDP decreases

- this also leads to a reduction in business investments due to an increase in costs, reducing economic growth

What is the impact of contractionary monetary policy on the current account?

- it depends on the strength of the link between intrerest rates and exchange rates

- a raising in interest rates lowers aggregate demand as consumer spending decreases due to the cost of borrowing increasing

- this reduces the demand for imports

- however, if interest rates increase, this could mean that the currency may appreciate

- this leads to exports becoming more expensive and imports becoming cheaper, worsening the current account

What is quantitative easing?

Quantitative easing is when the central bank buys financial assets from commercial banks, causing a flow of money from the central bank to commercial banks.

This extra money could be used by the commercial bank to facilitate more loans, increasing demand.

What is one of the drawbacks of quantitative easing?

It can be inflationary. This is because the money given to commercial banks does not exist and is created electronically. This is basically printing money, which reduces the purchasing power of money, causing inflation.