Monetary Policy: Macro

What is monetary policy?

Monetary Policy is the central bank’s use of:

• interest rates

• money supply controls (QE; digital money creation)

• exchange rate intervention (by Central Bank)

…to manage AD, influence economic activity and maintain price stability

What is the difference between 'expansionary' and 'contractionary' monetary policy?

Expansionary monetary policy: Inflationary

• Involves lowering interest rates (reduces cost of borrowing) → [+I, +C]

• Increasing money supply (through QE; digital money creation)

• Exchange rate depreciation (exports cheaper, imports dearer); FROM lower interest rates

To encourage spending and investment, shifting AD right

Contractionary Monetary Policy: Deflationary

• Involves raising interest rates (inc. cost of borrowing/reward for saving)

• Reducing money supply (Quantitative Tightening QT)

• Exchange rate appreciation (imports cheaper, exports dearer); FROM higher interest rates

To discourage spending and investment, shifting AD left

How QE → Increases money supply, hence increasing interest rates

• Central Bank increasing the money supply (QE; digital money creation) floods banks with liquidity.

• They then use these digital funds to buy assets (mainly issued bonds) from investors (usually big organizations that manage/invest large sums of money eg. commercial banks/ insurance companies)

• The transfer: CB pays investors for their bonds (deposits money to investors bank account; credit)

• This floods commercial banks with large sums of cash, forcing them to lower borrowing rates for the public

How QT → Decreases money supply, hence increases interest rates

• The Central Bank takes existing government bonds off its balance sheet and sells them back to private investors (eg. commercial banks/ insurance companies)

• Investors pay for these bonds using money from commercial bank accounts.

• Digital payment goes to Central Bank, and is destroyed

This drains commercial banks of large sums of cash, making cash supply scarce hence forcing them to raise borrowing rates for the public

How exchange rate depreciates

• As domestic savings and bonds offer lower returns, foreign investors withdraw their money to invest in countries where rates are higher

• They sell the domestic currency (eg: Pounds) on the foreign exchange market, increasing supply, hence decreasing value relative to foreign currencies (makes imports dearer, exports cheaper)

What is the primary aim of monetary policy? What are the secondary aims?

• Primary aim: maintaining price stability (UK CPI Inflation target: 2%

• Secondary aims: gov macroeconomic objectives

- Economic growth: strong and sustainable
- Inflation stability (2%)
- Low unemployment
- Balance of payments (trade surplus X>M)
- Low national debt
- Low levels of inequality
- High living standards and wellbeing
- Environmental Sustainability

Who are the Bank of England (BOE)? Who is the Monetary Policy Committee (MPC)? Who is the current Governor of the BOE? What are their roles? What are the names of other major central banks (USA, EU, China)?

• Bank of England (BoE): The UK’s central bank, operationalized independently to deliver monetary and financial stability.

• Government: fiscal policy, BoE: monetary policy

• Monetary Policy Committee ( ): A 9-member committee within the BoE responsible for setting official policy (the Bank Rate and asset purchases). It consists of the Governor, 3 Deputy Governors, the Chief Economist, and 4 external members appointed by the Chancellor.

• Current Governor: Andrew Bailey. Role: Chair of the MPC, leading policy decisions and communications.

• Major Central Banks:

  • USA: The Federal Reserve ("The Fed")

  • EU: European Central Bank (ECB)

  • China: People's Bank of China (PBoC)

What is the 'bank rate'? How/why do changes in the bank rate affect commercial/retail banks' interest rates?

• Bank Rate: The base interest rate set by the central bank, dictating baseline cost of borrowing/reward for saving across economy

• When the Bank Rate INCREASES: It drives up wholesale borrowing costs for commercial banks. To prevent their profit margins from being squeezed, banks pass these higher funding costs onto households and firms by raising interest rates on mortgages, credit cards, and loans.

• When the Bank Rate FALLS: It drops the baseline cost of cash across the banking system. To avoid losing customers to competing banks who cut their borrowing prices, commercial banks are forced by market competition to lower interest rates on loans and mortgages to attract and retain borrowers.

Can you analyse how interest rates can be used to achieve different macroeconomic objectives?

1. Strong & Sustainable Economic Growth

• Expansionary Policy (Decreasing Interest Rates): Cuts borrowing costs, incentivising household consumption (+C) and capital investment (+I). Aggregate Demand shifts right boosting Real GDP.

• Conflict: Unchecked growth via rate cuts risks demand-pull inflation and unsustainable debt bubbles.

2. Inflation Stability (2% Target)

• Contractionary Policy (Inc Interest Rates): Increases borrowing costs and the reward for saving, cooling spending (-C, -I). Reduces demand-pull inflation (dec AD & PL). Higher rates also strengthen the exchange rate, reducing imported cost-push inflation for firms (-M).

3. Low Unemployment

• Expansionary Policy (Dec Interest Rates): Derived demand for labour rises as businesses expand to meet higher AD (consumers have higher PP).

• Conflict (Phillips Curve): Driving unemployment too low leads to wage-push inflation.

4. Balance of Payments (Trade Balance: X > M)

• Contractionary Policy (Inc Interest Rates): Reduces domestic income, suppressing import spending (-M).

• Conflict: High interest rates attract foreign investors (^returns), appreciating the exchange rate. This makes exports expensive (-X) and imports cheap (+M), worsening the trade balance.

5. Low National Debt

• Expansionary Policy (Dec Interest Rates): Lower interest= (+C+I), so AD and RGDP increase. +AD means firms hire more workers to expand output, raising firms profit and creating jobs/+wages, lowering gov debt burden due to more tax payments.

• Conflict: Can increase demand pull inflation, lowering value of money and peoples PP. Hence they will -C, slowing down economic growth

6. Low Levels of Inequality

• Contractionary Policy (Inc Interest Rates): High interest rates depress asset prices (housing, equities), reducing the wealth of asset owners.

• Conflict: High interest rates increase mortgage payments for lower-income households and worsen unemployment, disproportionately hurting vulnerable workers.

8. Environmental Sustainability

• Contractionary Policy (Inc Interest Rates): Slower economic growth decreases resource extraction, industrial output, and carbon emissions.

• Conflict: High interest rates increase the capital costs for green energy investments (wind, solar, grid infrastructure).