📈 Expansionary (loose)
A lower interest rate or a larger money supply. Borrowing is cheaper, so total demand tends to rise.
Monetary Policy » Monetary Policy
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 4.3.1, 4.3.2, 4.3.3
- What the money supply and monetary policy are
- The three monetary policy measures: the interest rate, the money supply and the foreign exchange rate
- How monetary policy may help a government reach each of its macroeconomic aims
- How to write a short chain of cause and effect for each aim
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Unlock This CourseMoney supply and monetary policy
The last lesson showed how a government can use taxes and spending to steer the economy. There is a second set of tools. Instead of changing taxes, a government (usually through its central bank) can change how expensive money is to borrow and how much money is moving around.
Key terms:
- Money supply: the total amount of money in an economy.
- Monetary policy: the use of changes in the interest rate, the money supply and the foreign exchange rate to influence the economy and help achieve the government's macroeconomic aims.
Remember, the central bank is the government's bank and sets the main interest rate. In many countries it is the central bank that carries out monetary policy for the government.
The three monetary policy measures
There are three levers. Each can go up or down.
🏦 Interest rate
The interest rate is the price of borrowing money and the reward for saving it. A higher rate makes loans dearer and saving more rewarding. A lower rate does the opposite.
💵 Money supply
The amount of money in the economy can be increased or reduced. More money makes it easier for banks to lend and people to spend. Less money does the opposite.
💱 Foreign exchange rate
This is the price of the country's currency in terms of other currencies. A government may try to make it lower or higher, for example by changing the interest rate or by buying or selling its own currency. The full reasons come in a later lesson.
Loose and tight policy
📉 Contractionary (tight)
A higher interest rate or a smaller money supply. Borrowing is dearer, so total demand tends to fall.
Worked example: Brenvia
Brenvia is a made-up country in a slump. Its central bank cuts the interest rate from 6% to 3%. A family wanting a new car finds the loan much cheaper, so they borrow and buy it. A firm decides a new machine is now worth buying with a loan. Saving pays less, so some households spend instead of saving. Total demand rises. This is an expansionary monetary policy.
How monetary policy helps each macroeconomic aim
A government may use monetary policy to move towards each of its macroeconomic aims. Below is one short chain for each aim. The word may matters: these are the ways it can work, not guarantees. Judging how well each policy works comes in later lessons on each aim.
1. Economic growth
Lower the interest rate, so borrowing becomes cheaper. Households borrow and spend more, and firms borrow to invest. Total demand rises, firms produce more and real GDP rises.
2. Full employment
Increase the money supply, so banks can lend more. Firms borrow to expand and sell more. They need more workers, so unemployment may fall.
3. Stable prices
Raise the interest rate, so borrowing is dearer and saving more rewarding. Households and firms spend less. Total demand falls, so firms find it harder to raise prices and inflation may slow.
4. Balance of payments stability
Lower the foreign exchange rate. The country's exports become cheaper for foreign buyers and imports become dearer for home buyers. Export sales may rise and spending on imports may fall, so a current account deficit may shrink.
5. Redistribution of income
Lower the interest rate, so total demand and output rise. Firms hire more workers. People who were unemployed now earn wages, so the gap between low and high incomes may narrow.
6. Environmental sustainability
Raise the interest rate, so loans are dearer. Firms borrow less to build new factories and households borrow less to buy goods. Less is produced and consumed, so pollution may fall.
Common mistakes
- Saying a higher interest rate is expansionary. Higher rates make borrowing dearer, so spending falls. It is contractionary.
- Mixing up monetary and fiscal policy. Monetary policy is about interest rates, the money supply and the exchange rate. Taxes and government spending are fiscal policy.
- Writing "it reduces inflation" with no steps. Show the chain: dearer borrowing, then less spending, then lower total demand, then slower price rises.
Exam-style question
Dalvonia is a made-up country. Its economy is growing slowly and many workers are unemployed. The central bank decides to cut the interest rate.
(a) Define monetary policy. [2 marks]
(b) Identify two monetary policy measures. [2 marks]
(c) Analyse how a cut in the interest rate may help Dalvonia to reduce unemployment. [6 marks]
Model answer
(a) Monetary policy is the use of changes in the interest rate (1), the money supply and the foreign exchange rate (1) to influence the economy and achieve macroeconomic aims.
(b) A change in the interest rate (1). A change in the money supply (1). (A change in the foreign exchange rate also gains the mark.)
(c) A lower interest rate makes borrowing cheaper (1). Households borrow and spend more (1) and firms borrow more to invest (1). Total demand rises (1). Firms sell more and produce more, so they need extra workers (1). More people are employed, so unemployment may fall (1).
Exam tip
In "Analyse" answers, start from the lever (the interest rate) and finish at the aim (unemployment). Join every step with "so" or "which means".