Monetary Policy 4.4

What is monetary policy?

Actions taken by a government to try to control either the supply of money in the economy or the price of money.

Interest rates

The price of borrowing/reward for saving money.

Money supply

Amount of money flowing around in the economy

Open market operations

The central bank buying or selling government securities/government bonds to control money supply and interest rates, increasing or decreasing economic activity. 

Effect of expansionary monetary policy on AD (aggregate demand)

Interest rates fall, leading to
Consumers borrow more, leading to more spending.
Mortgage repayments fall, which means that people have more disposable income.
Firms borrow more, leading to higher investments and higher AD.

Effect on contractionary monetary policy on AD (aggregate demand)

Interest rates rise, leading to
Consumers borrow less, resulting in reduced spending.
Mortgage repayments increase, meaning people have less disposable income.
Firms borrow less, leading to lower investments and decreased AD.

The effectiveness of monetary policy is largely determined by:

Length of time lag, depth of recession, amount interest rates can be moved

What does the length of time lags determine the effectiveness?

Determines how accurately central banks can see the current economy, which impacts the effectiveness of the policy. Longer lags can lead to responses to outdated information.

How does the depth of the recession determine effectiveness?

If the recession is serious, then the monetary policy will be ineffective to boost AD. Because if the recession is deep, unemployment will rise, and people will fear losing their jobs, so lower interest rates will also do little to increase consumption in this circumstance.

How does the amount of interest rates change determine effectiveness?

Most central banks only change it by a small margin, which won’t affect AD by a significant amount, causing it to be a slow process with small changes.

What happens when interest rates increase?

Increases reward for saving and increases the cost of borrowing.