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Government Policies » Monetary Policy and Interest Rates

What you'll learn this session

Study time: 30 minutes

Edexcel spec: 2.1.2 (b)

What monetary policy is and who sets it
How a change in interest rates affects consumers and businesses
How interest rate changes help to reach macroeconomic objectives
What asset purchasing (quantitative easing) is

This topic is examined on Paper 2: Macroeconomics and the Global Economy.

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What is monetary policy?

Governments have more than one way to steer the economy. Last time you met fiscal policy, which uses taxes and spending. Monetary policy is different. It works through the cost of borrowing money, so it focuses on interest rate changes.

Remember, an interest rate is the cost of borrowing money, and the reward for saving it, shown as a percentage. Monetary policy changes that percentage across the whole economy.

Key terms:

Monetary policy: policy that uses changes in interest rates to influence the economy. It is carried out through the central bank.
Central bank: the national bank that sets the main interest rate for the whole country.
Base rate: the main interest rate set by the central bank. Other banks use it as a guide for their own rates.
Mortgage: a large loan used to buy a home, paid back with interest over many years.
Asset purchasing (quantitative easing): when a central bank creates new money and uses it to buy assets, such as government bonds (loans to the government that investors buy and the government repays later with interest), from banks and investors.

The role of the central bank

The central bank sets interest rates, which changes the cost of borrowing across the whole economy

Most countries have a central bank. In the UK it is the Bank of England. In the USA it is the Federal Reserve. The central bank decides the base rate, usually at regular meetings, and it chooses a rate to help the country reach its macroeconomic objectives.

High street banks and building societies watch the base rate closely. When it moves, they usually move their own rates for savers and borrowers in the same direction.

📈 Interest rates rise

Borrowing becomes more expensive and saving pays more. People and firms spend and invest less. This is used to slow the economy down.

📉 Interest rates fall

Borrowing becomes cheaper and saving pays less. People and firms spend and invest more. This is used to speed the economy up.

How interest rate changes affect consumers

Higher interest rates mean bigger mortgage payments, so households have less left to spend

Consumers are affected in three main ways.

Borrowing: a higher rate makes loans and credit cards more expensive, so people borrow and spend less. A lower rate does the opposite.
Saving: a higher rate rewards savers more, so more people save and spend less now. A lower rate makes saving less attractive, so more is spent.
Mortgages: many homeowners pay a mortgage rate that follows the base rate. When rates rise, monthly payments rise, so they have less left to spend on other things. When rates fall, payments fall and they have more to spend.

Overall, consumer spending falls when interest rates rise and increases when they fall.

Worked example

Anya has a mortgage of 100,000 pounds in Country Brelan. She pays interest only, to keep the sums simple.

At 3%: interest = 100,000 × 3 ÷ 100 = 3,000 pounds a year, or 250 pounds a month.

After the central bank raises rates, her mortgage rate goes to 5%: interest = 100,000 × 5 ÷ 100 = 5,000 pounds a year, or about 417 pounds a month.

Her payments rise by 2,000 pounds a year. That is money she can no longer spend in shops, so consumer spending falls.

How interest rate changes affect businesses

Firms often borrow to pay for investment, such as new machines, vans or factories. A lower interest rate means the loan costs less, so more investment plans look worth doing. A higher rate makes loans more expensive, so firms cut back on investment.

Firms are also affected by consumers. If households spend less because rates are high, firms sell less and have less reason to invest.

The effect on macroeconomic objectives

Because spending and investment change, total demand in the economy changes too. That affects the objectives you have already met.

Inflation: higher rates reduce spending, so demand-pull pressure eases and price rises slow down. Lower rates can push inflation up.
Economic growth: lower rates raise spending and investment, which helps output to grow. Higher rates slow growth.
Unemployment: if firms sell and produce more, they may hire more workers, so unemployment can fall. If rates are high and spending drops, jobs may be lost.

So a central bank may raise rates to control rising prices, and cut rates to help a weak economy. Be ready to say that these choices can pull in different directions.

Asset purchasing (quantitative easing)

Sometimes interest rates are already very low and the economy is still weak. The central bank cannot cut much further. It may then use asset purchasing, also called quantitative easing.

The central bank creates new money electronically.
It uses the money to buy assets, such as government bonds, from banks and other investors.
Banks now hold more money, and the extra demand for bonds helps to keep longer-term interest rates low.
Borrowing is cheaper and easier, so spending and investment can rise.

For this course you only need to be aware of what it is and why central banks use it.

Common mistakes

Mixing up monetary and fiscal policy. Monetary policy changes interest rates. Fiscal policy changes taxes and government spending.
Saying the government sets the base rate. It is the central bank.
Forgetting the chain. Do not just write "rates rise so inflation falls". Explain that borrowing costs more, spending and investment fall, demand falls, and so price rises slow down.
Writing that higher interest rates make people want to borrow more. They make borrowing less attractive.

Exam-style question

Country Zorin has fast-rising prices. Its central bank raises the base rate from 2% to 4%.

(a) Define the term 'monetary policy'. [2 marks]

(b) State two macroeconomic objectives that a change in interest rates can influence. [2 marks]

(d) Analyse how the rise in the base rate may help Zorin to reduce inflation. [4 marks]

Model answer

(a) Monetary policy is policy (1) that uses changes in interest rates to influence the economy (1).

(b) Any two of: inflation (1), economic growth (1), unemployment (1).

(c) Higher interest rates make borrowing more expensive (1), so people take out fewer loans and use credit cards less (1). Homeowners with a mortgage pay more each month (1), leaving them less money to spend. Saving also pays more, so some people save instead of spending (1).

(d) A higher base rate raises the cost of borrowing (1), so consumers spend less and firms invest less (1). Total demand in the economy falls (1), so demand-pull pressure on prices eases and the rise in prices slows down (1).

Exam tip

For an 'analyse' part like (d), build a chain of linked steps, each one leading to the next, from the interest rate change all the way to inflation.

Recap

Monetary policy uses changes in interest rates to influence the economy.
The central bank sets the base rate, and other banks follow it.
Higher rates make borrowing more expensive, raise mortgage payments and cut consumer spending and business investment. Lower rates do the opposite.
These changes affect inflation, economic growth and unemployment.
Asset purchasing (quantitative easing) is when a central bank creates money to buy assets, to keep borrowing cheap.

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