monetary policy

What is monetary policy?

Monetary policy is an action that a country central bank or government can take to influence how much money is in the economy and how much it costs to borrow.

Controls inflation

Definition

Monetary policy is the use of interest rates, money supply, and other tools by a country's central bank (e.g., Bank of England, Federal Reserve, ECB) to influence: Aggregate Demand (AD), Inflation, Employment and Economic growth

Who is responsible for implementing monetary policies

Central banks are responsible for implementing the monetary policy of governments which may involve inflation targeting with the use of interest rate policy and quantitative easing

How does the MPC use changes in the bank rate to achieve objectives for monetary policy?

the main objective is to satisfy the gov objective of stable inflation. the base rate typically sets the interest rate across the country and so when inflation is high, interest rates are usually increased and vice versa.

what factors are considered by the MPC when setting the bank rate?

Unemployment rate, GDP growth and spare capacity, bank lending + consumer credit figures, house prices, consumer + business confidence, Exchange rate

What are the types of monetary policy

Expansionary policy and contractionary policy

what is expansionary policy?

Aim: Boost growth, reduce unemployment.

Tools:

Lower interest rates → cheaper borrowing, more spending & investment.

Quantitative easing (QE) → central bank buys assets to inject liquidity.

Effect: AD shifts right → higher output, possibly higher inflation.

What is contractionary policy

Aim: Reduce inflation, stabilise overheating economy.

Tools:

Raise interest rates → borrowing costly, saving attractive.

Reduce money supply / unwind QE.

Effect: AD shifts left → lower inflation, but may increase unemployment.

what are the microeconomic objectives

F - fairness(equity)

E - Efficiency (allocative/productive/dynamic)

E - Environmental sustainability

C - Correct market failure

E - Enhance competition & consumer welfare

Efficiency

Allocative efficiency: resources go where they are most valued.

Productive efficiency: lowest cost production.

Dynamic efficiency: innovation and investment.

Equity / Fairness

Reduce inequality through taxes, welfare, redistribution.

Correcting Market Failure

Externalities (pollution, smoking).

Public goods (street lighting, defence).

Information failure (health risks, financial products).

Competition & Consumer Welfare

Prevent monopolies abusing power.

Encourage innovation and choice.

Environmental Sustainability 🌱

Internalise costs of climate change, pollution, overuse of resources.

What are the macroeconomic objectives?

T - TRADE BALANCE

I - INFLATION LOW

G - GROWTH STEADY

E - EMPLOYMENT HIGH

R - RESPONSIBLE FISCAL POLICY

Economic Growth 📈

Sustained rise in real GDP.

Creates jobs, raises living standards.

Low & Stable Inflation 💰

Usually target around 2% (UK, Eurozone).

Too high → erodes purchasing power.

Too low/deflation → discourages spending.

Low Unemployment / High Employment 👷

Aim for low cyclical unemployment.

Ensures resources (labour) are fully used.

Balance of Payments Stability 🌐

Avoid large trade/current account deficits.

Maintain competitiveness in global markets.

Government Finances / Fiscal Stability (sometimes added)

Keep national debt manageable.

Avoid unsustainable deficits.

What are the three tools the central bank can use to influence the money supply or cost of borrowing to reach macroeconomic objectives

1. Interest Rate Policy (Base Rate)

Central bank sets the policy/base rate.

This influences commercial bank lending and borrowing costs.

Lower rates → borrowing cheaper, saving less attractive → consumption & investment ↑ → AD shifts right.

Higher rates → borrowing more expensive, saving attractive → consumption & investment ↓ → AD shifts left.

✅ Most common tool (Bank of England's MPC meets monthly to decide).

2. Quantitative Easing (QE) / Open Market Operations

Central bank buys or sells financial assets (mainly government bonds).

Buying bonds → increases money supply, lowers long-term interest rates, stimulates spending & investment.

Selling bonds → reduces money supply, raises yields, slows economy.

Used heavily during the 2008 Financial Crisis and COVID-19.

3. Reserve Requirements (and other regulatory tools)

Central bank controls how much commercial banks must hold in reserves against deposits.

Lower reserve ratio → banks can lend more → money supply ↑ → stimulates AD.

Higher reserve ratio → banks lend less → money supply ↓ → reduces inflationary pressure.

Not used often in the UK, but more common in the US/China.

4. Exchange Rate Policy (sometimes included)

Central bank can intervene in foreign exchange markets.

Depreciation (lower exchange rate):

Makes exports cheaper abroad → ↑ export demand.

Imports more expensive → boosts domestic production.

Shifts AD right (growth ↑, inflationary pressure ↑).

Appreciation (higher exchange rate):

Makes exports dearer, imports cheaper.

AD shifts left (slower growth, lower inflation).

⚠️ In the UK (and most advanced economies), the exchange rate is free-floating, so direct intervention is rare. But in countries like China, central banks actively manage it.

what are interest rates

Interest rate are the cost of borrowing rates of return on savings

what are the effects of increase in interest rates

1. On Aggregate Demand (AD)

Consumption ↓: Borrowing becomes more expensive (loans, mortgages, credit cards), and saving becomes more attractive → households spend less.

Investment ↓: Firms face higher borrowing costs, so fewer capital projects are wprofitable.

Net exports ↓: Higher interest rates attract foreign investors → exchange rate appreciates → exports more expensive, imports cheaper → demand for UK goods abroad falls.

👉 Overall: AD shifts left → lower output & growth.

2. On Inflation

Demand-pull inflation falls (less spending & investment).

Cost-push inflation may ease too if stronger currency lowers import prices (e.g., oil, raw materials).

Central banks usually raise rates to meet their inflation target (e.g., 2%).

3. On Employment

Slower growth means firms cut back hiring.

Unemployment may rise (especially cyclical unemployment).

4. On Government Finances

Lower growth → less tax revenue, higher welfare spending.

But higher rates mean government debt interest payments ↑.

5. On Different Groups

Savers benefit: Higher returns on savings.

Borrowers lose: Mortgage, credit card, and loan repayments ↑.

Firms: Especially small businesses reliant on loans may struggle.

Homeowners: Housing market may slow as mortgages cost more.

6. On Long-Run Effects

If inflation expectations fall, stability ↑.

But if rates stay high too long → risk of recession, investment slowdown, lower long-term growth.

When is quantitative easing used?

QE = unconventional monetary policy used when interest rates are already very low (near 0%) and cannot be cut further.

Central bank (e.g., Bank of England, Federal Reserve, ECB) creates new money electronically and uses it to buy financial assets (mainly government bonds).

e.g during financial crisis- interest rates were low and AD was not stimulated because of:

low availability of credit

low consumer/business confidence

low willingness of banks to lend

QE was introduces had a direct impact on the money supply

how does QE work?

How QE Works - Step by Step

Central bank creates money

Not printed cash — just electronic reserves in the banking system.

Buys government bonds (and sometimes corporate bonds)

This pushes up the price of bonds.

Since bond prices ↑, their yields (interest rates) ↓.

Lower yields reduce borrowing costs

Government can borrow more cheaply.

Firms and households also face lower interest rates on loans & mortgages.

Increases liquidity in financial system

Banks now have more cash (from selling bonds).

Encourages them to lend more to businesses and consumers.

Boosts Aggregate Demand (AD)

Cheaper borrowing → higher investment (I) and consumption (C).

Wealth effect: Rising asset prices (bonds, shares, housing) make people feel richer → they spend more.

Intended Outcomes

Stimulate economic growth.

Raise inflation towards target (often 2%).

Reduce unemployment during recessions.

Risks / Limitations ⚠️

Banks might hoard cash instead of lending (esp. if confidence is low).

May inflate asset bubbles (stock markets, housing).

Can worsen inequality (benefits asset owners more).

Hard to reverse without destabilising markets.

👉 Exam tip phrase:

QE is when a central bank creates new money to buy bonds, lowering yields and boosting lending, spending, and investment. It aims to raise AD and inflation, but may cause asset bubbles and inequality.

exchange rate

the exchange rate is the purchasing power of a currency in terms of what it can buy from other currencies

what happens when you change the exchange rate?

the central bank can affect the prices of imports and exports this can allow the balance of payments target of being in a surplus to be reached.

1. If the Exchange Rate Appreciates (currency gets stronger) 💷⬆️

Exports: More expensive for foreigners → demand for exports ↓.

Imports: Cheaper for domestic consumers → demand for imports ↑.

Net Exports (X − M): Falls → reduces AD.

Inflation: Likely to fall because imports (e.g., oil, raw materials) are cheaper.

Growth: Slows (less demand for exports, AD shifts left).

Employment: May fall in export industries.

👉 Mnemonic: SPICED

2. If the Exchange Rate Depreciates (currency gets weaker) 💷⬇️

Exports: Cheaper for foreigners → demand for exports ↑.

Imports: More expensive for domestic consumers → demand for imports ↓.

Net Exports (X − M): Rises → boosts AD.

Inflation: Likely to rise because imports (oil, food, materials) cost more.

Growth: Increases (export-led growth, AD shifts right).

Employment: Higher in export industries.

👉 Mnemonic: WIDEC

3. Depends on PED (Price Elasticity of Demand) for Imports/Exports

Marshall-Lerner Condition: A depreciation will only improve the trade balance if the sum of elasticities of demand for exports + imports > 1.

J-Curve Effect: After depreciation, trade balance might worsen in the short run (contracts already in place, takes time to adjust), but improves in the long run.

✅ Exam tip phrase:

An appreciation reduces AD by making exports less competitive and imports cheaper (SPICED). A depreciation increases AD by boosting exports and making imports more expensive (WIDEC), though effects dependent on elasticities and time lags (Marshall-Lerner & J-curve).

exchange rate effects on import price's?

interest rates fall, exchange rate falls

export prices fall, export demand rises

import prices will rise so demand for import falls

leads to balance of payments surplus

how does the ER affect AD and macroeconomic policies?

SPICED & WPIDEC used to remember effect of exchange rate on exports and imports .

Exchange Rate → AD

Appreciation of pound (stronger currency):

(SPICED)

Exports ↓ (dearer abroad), Imports ↑ (cheaper at home).

Net exports (X − M) ↓ → AD shifts left.

Slows growth, reduces inflationary pressure.

Depreciation of pound (weaker currency):

(WPIDEC)

Exports ↑ (cheaper abroad), Imports ↓ (dearer at home).

Net exports (X − M) ↑ → AD shifts right.

Boosts growth, raises inflationary pressure

Effects on Macroeconomic Objectives

Growth:

Appreciation slows GDP growth (AD ↓).

Depreciation boosts GDP growth (AD ↑, especially export-led).

Inflation:

Appreciation reduces imported inflation (e.g., cheaper oil, food).

Depreciation raises imported inflation → cost-push pressure.

Employment:

Appreciation → jobs lost in export industries (fall in demand).

Depreciation → jobs gained in export/manufacturing industries.

Balance of Payments:

Appreciation worsens current account (exports fall, imports rise).

Depreciation improves current account (exports rise, imports fall), provided Marshall-Lerner condition holds.

3. Interaction with Macroeconomic Policies

Monetary Policy (interest rates):

Higher interest rates often → currency appreciation (foreign investors attracted).

Lower rates → depreciation (capital outflows).

So central banks must balance inflation control with ER effects.

Fiscal Policy:

If expansionary (↑ Gs, ↓ T), AD ↑, imports may rise, worsening current account → pressure on ER.

If contractionary, opposite happens.

Supply-Side Policy:

If successful (productivity ↑), exports become more competitive regardless of ER.

Helps balance of payments even if ER is strong.

what is the current account and what does "current account worsens" mean?

What is the Current Account?

The current account is part of a country's Balance of Payments.

It mainly records:

- Exports (X) - money coming into the country from selling goods/services abroad.

- Imports (M) - money flowing out of the country from buying foreign goods/services.

The balance is Net Exports (X − M).

- If X > M, you have a current account surplus (more money coming in).

- If M > X, you have a current account deficit (more money going out).

What does "current account worsens" mean?

It means the trade deficit gets bigger (or the surplus shrinks).

Imports are rising faster than exports.

So, more money is flowing out of the economy than flowing in.

EXAMPLE:

Imagine the UK has:

Exports = £100bn

Imports = £120bn

Current account = −£20bn (deficit)

Now the government cuts taxes (↓T).

Households feel richer → buy more iPhones, German cars, French wine (imports ↑).

Imports rise to £140bn, exports still £100bn.

Current account = −£40bn (bigger deficit)

👉 This is what economists mean when they say the current account worsens — the gap between imports and exports gets worse.

what does SPICED stand for?

S-strong

P-pound

I-imports

C-cheap

E-exports

D-dear

What does WPIDEC stand for?

W- Weak

P- Pound

I- Imports

D- Dearer

E- Exports

C- Cheaper

what does it mean when a currency is strong?

when a currency is strong against other countries they can buy more of that currency and therefore more goods from that country

this means that imports are cheap but it is more expensive to for other countries to buy from that country as their currency is higher making exports more expensive

what are the three things the government can use to influence monetary policies?

interest rates

money supply

exchange rate

monetary transmission mechanism (MPTM) if interest rates go up

-Borrowing ↓, Saving ↑

Loans are more expensive → households/firms borrow less.

-Saving becomes more attractive (higher opportunity cost of spending).

-Asset Prices ↓

Lower demand for houses, shares, bonds.

Negative wealth effect → people feel poorer, spend less.

-Confidence ↓

Expectations for future growth weaken → lower consumption & investment.

-Domestic Demand ↓ (C + I + G)

Consumption falls (C).

Investment falls (I).

Government spending (G) may also tighten if fiscal policy aligns.

-Exchange Rate ↑ (appreciation)

Higher interest rates attract hot money inflows.

Foreign investors buy domestic assets → demand for the currency ↑.

Currency appreciates.

-External Demand ↓ (X - M)

SPICED: Strong Pound → Imports Cheap, Exports Dear.

Exports fall, imports rise → net exports (X - M) ↓.

-Aggregate Demand (AD) ↓

Both domestic and external demand fall → AD shifts left.

-Inflationary Pressure ↓

Less demand → lower demand-pull inflation.

Cheaper imports reduce cost-push inflation.

Deflationary pressures may emerge.

summary of monetary transmission mechanism (MPTM) if interest rates go up

Higher interest rates → less borrowing, more saving → negative wealth/confidence effects → currency appreciates (SPICED) → exports fall, imports rise → AD falls → inflationary pressure ↓.

monetary transmission mechanism (MPTM) if interest rates go down

Savings ↓

Lower reward for saving (opportunity cost is low).

Borrowing ↑

Loans are cheaper → households borrow for spending, firms borrow to invest.

Asset prices ↑

Higher demand for housing, stocks, bonds → boosts wealth.

Confidence ↑

Positive wealth effect → people feel richer, spend more.

Exchange rate ↓ (currency depreciates)

Hot money outflows (investors move money abroad for higher returns).

→ WPIDEC: Weak Pound → Imports Dear, Exports Cheap.

Demand

Domestic demand rises (C + I + G).

External demand rises (exports more competitive).

Inflationary pressures ↑

Demand-pull inflation from higher AD.

Cost-push inflation from more expensive imports (imported inflation).

summary of monetary transmission mechanism (MPTM) if interest rates go down

Lower interest rates → more borrowing, less saving → asset prices & confidence up → currency weakens (WPIDEC) → AD rises (domestic + external) → inflation increases.

wealth effect

when changes in the value of people assets influence their spending behavior

hot flow of money

is a flow of money between countries and whole purpose of this money is to invest it in countries where there is high interest rate of return

investment

when firms purchase assets (tech, machinery) to increase production

market interest and official interest

market interest is set by commercial banks decide to charge you

official interest rate is set by central bank by MPC

Evaluation points

-Time Lag

Changes in the official interest rate take time to affect the economy.

Market interest rates, borrowing, spending, and investment may take around 6 months or more to respond.

-Wealth Effect Size

Depends on:

How much asset prices (stocks, housing) increase or decrease.

How much confidence households and firms have.

A large asset price rise + high confidence → strong wealth effect; weak confidence → muted effect.

-Impact on Consumption & Investment

Determined by marginal propensity to consume (MPC) and marginal propensity to invest (MPI).

High MPC/MPI → bigger boost to spending from lower interest rates → stronger multiplier effect.

Low MPC/MPI → weaker overall impact.

-Inflation Response

Depends on elasticities of supply:

If supply is inelastic, increased demand → higher prices → stronger inflation.

If supply is elastic, increased demand → smaller price rise → weaker inflation.

monetary transmission mechanism (MPTM)

shows the relationship between interest rates and exchange rates

also shows which parts of the economy are affected by change sin interest rates and why

changes in interest rates affect:

AD

Output

Prices.

Explain the monetary transmission mechanism

higher interest rates would cause banks to increase their market interest

this would reduce the marginal propensity to consume and increase the marginal propensity to save.

causing asset prices to decrease as the demand for them has fallen and the cost of borrowing to increase. increasing the value of debt for consumers and businesses

this has a negative effect on households as confidence in overall economy has decreased.

causes consumption and investment to fall, simultaneously an inflow of hot money due to high interest would increase demand for sterling.

this causes the pound to appreciate making imports cheap and exports dear. a fall in domestic and international demand would lead to fall in AD causing inflationary pressure in economy leading to the CPI falling.

change in in interest effect on domestic demand (C+I+G)

Lower rates encourage consumer spending and business investment due to cheaper borrowing

change in in interest effect on AD

decrease in AD increase in interest rates

contractionary monetary policy

increase in AD decreases in interest rates expansionary monetary policy

depends on sensitivity of inflation and consumption

change in in interest effect on domestic inflationary pressures

build up in demand grows faster the economies potential to produce

this happens when actual GDP exceeds the economies productive capacity pushing up prices

change in in interest effect on consumer price inflation

overall rise in the price level of goods and services

relationship between interest rate and exchange rates

their relationship is proportional as interest rates go up exchange rates go up (strengthen)

relationship between interest rates and inflation rates

it is opposite

as interest rates go up inflation rates go down

pros of tackling inflation

exports and imports are affected by positive multiplier gains that cause changes in AD and AS

dual impact on AD and AS; it can solve external shocks to demand and supply

target inflation keeps a macroeconomic indicator reaching its target

cons of tackling inflation

can cause demand-pull inflation if interest rates are low and borrowing is cheap

reactions may not be as expected consumers spend and businesses invest on business confidence

time lag of 18 months for interest rates to affect consumers