Revision - monetary policy

Monetary Policy

What is monetary policy?

It is the control of the money supply and interest rates by a countries central bank to influence the economy.

How monetary policy works in normal times?

Main tool; Changing the policy interest rate

Expansionary (Loosening) Monetary policy

• central banks cut interest rates

• This makes borrowing cheaper, encouraging consumer spending and investment

• Also lowers the return on domestic assets = currency depreciates = exports become cheaper

• All this increases aggregate demand

GDP increases

Contractionary (tightening) Monetray policy;

Central banks raises interest rates

Slows borrowing and spending

Helps cool inflation

The MPC story; transmission Mechanism

MPC is how much people spend out of each extra dollar they get

Monetary policy is more powerful when MPC is high - as people respond quickly to rate cuts by increasing consumption

But there’s a catch;

• If households are already in debt, or uncertain about the future, they may save instead of spend.

• That weakens the effect of rate cuts

What happens when interest rate hit Zero?

After major shocks, central banks cut interest rates to near 0%.

But you can’t go much lower than (zero lower bound)

At this point, traditionally monetary policy loses power

So central banks turn to unconventional tools- that’s where QE comes in

Quantitative easing

What is QE?

QE = Large scale asset purchases by the central bank

Central banks creates digital money to buy;

• Government bonds

• Mortgage backed securities

• Corporate bonds

Main goal

• Lower long term interest rate (short term are already near 0)

• Increase asset prices

• Stimulate credit and spending

• Prevent deflation

Transmission mechanism

1. CB buys bond - bond prices increase and yields decrease

2. Lower yields means cheaper borrowing for firms and households

3. Investors move to riskier assets (stocks, corporate bonds) - wealth effect

4. Higher asset prices make people feel wealthier - consumption increases

5. Increased liquidity in banking systems - more lending

QT - Quantitative tightening

After years of QE, central banks built up huge balance sheets.

QT = process of shrinking the central banks balance sheet

How?

• Stop reinvesting when bonds mature

• Or actively sell assets

Goals of QT

• Remove excess liquidity

• Allow interest to rise naturally

• Reduce inflationary pressure

• Qt is a form of monetary tightening but

• It’s slower and more passive than rate hikes

• It can still push up long term interest rates

🎯 Why QE Was Used (and Controversial)

🛠 QE was used because:

Interest rates were at zero

Inflation was too low

Economies needed stimulus

😬 But it's controversial:

May inflate asset bubbles

Widen inequality (rich benefit more from rising asset prices)

Hard to unwind (markets get addicted to cheap money)

May weaken currency, creating global tensions

🧾 Summary Table

Tool Normal Monetary Policy QE QT

Purpose Control short-term rates Stimulate at ZLB Normalize after QE

Method Adjust policy interest rate Buy assets (bonds) Let assets roll off or sell them

Effect Affects borrowing/lending Lowers long-term rates, boosts spending Tightens liquidity

Used in “Normal” times Recessions, deflationary periods Post-crisis, hig