Monetary Policy and AD

How do interest rates affect consumption?

Low rates = lower marginal propensity to save and a higher marginal propensity to consume due to lower borrowing costs.

How do interest rates affect investment?

Low rates = investment projects become less costly / more profitable thus more attractive, so investment should rise.

How do interest rates affect net exports?

Low rates = weaker £ as less attractive to currency investors. This means stronger exports and fewer imports, increasing net exports.

Wealth effect - definition

Falling rates = greater demand for housing through more affordable mortgages means rising house prices.

Homeowners can then borrow against the increase value of their home, increasing consumption

Increased house prices also improves consumer confidence.

Savings ratio - explanation

High rates = higher savings ratio as a higher proportion of income likely to be saved and therefore less spent on consumption.

Lower rates = lower incentive to save as reward is small.

Expansionary monetary policy: Diagram and explanation

1. If BoE is concerned that slow growth will lead to falling inflation., they may cut interest rates

2. This will cause AD to shift rightward, as this increases C, I and (X-M)

   1. Increases RNO from Y to Y1, creating employment

Contractionary monetary policy: Explanation and diagram

1. If BoE is concerned that inflation is rising above the 2% target, they may increase interest rates to reduce inflationary pressure.

2. Makes savings more attractive, reducing consumption and investment

3. AD shifts left, causing PL to fall from P1 to P2.

4. Comes at the expense of RNO, increasing unemployment and slowing growth.

Supply side effects (LRAS) of monetary policy: Diagram and Explanation

1. A cut in rates might stimulate investment into capital to improve firms’ productivity and efficiency, causing LRAS to shift right.

2. As investment is a component of AD, AD shifts right.

3. Productive capacity has increased and increases in AD can feed through to higher growth and employment with potentially little change in price level.

What does the effectiveness of monetary policy depend on? (8)

• The size of the change in interest rates

• Timing of rate changes

• The size of the multiplier

• The stage of the economic cycle that the economy’s at

• Time lag (how long it takes for changes to come into effect)

• Primary target is control of inflation, but may conflict with other objectives

• BoE might be hampered with inaccurate data

• Less effective with cost push causes of inflation