Monetary Policy

A-level Economics

What it is. What it affects. How it is used.

Definition: 'Monetary policy is the use of interest rates and money supply to achieve the macroeconomic objectives such economic growth and inflation.'

Monetary policy is usually controlled by a country’s central bank

Monetary policy is mainly used as a demand-side policy. This means that its use is used to influence the level of spending/aggregate demand.

How is monetary policy used in the UK?

In the UK, monetary policy is controlled by the Monetary Policy Committee (MPC) of the Bank of England. They are in charge of controlling the Bank of England's interest rate (also known as the bank rate or base rate).

How is Monetary Policy Used?

To change the level of aggregate demand (spending): Let's say for example that the level of spending in the economy is lower than it should be. Aggregate demand is increasing more slowly than we would like, and therefore our economy is growing at below the trend rate of growth. The Central Bank (in the UK, this is the Bank of England), may take this information and change the level of the base rate. Monetary policy can be expansionary or contractionary.

Expansionary Monetary Policy: If the interest rate is lowered this will tend to increase the level of spending and thus, aggregate demand. Why? Because with a lower rate of interest there is less incentive to save, more incentive for consumers to borrow (mortgages, loans and credit cards) and more incentive for firms to borrow (capital investment).

In the diagram above, the central bank has decreased the interest rate. It has incentivised spending and borrowing and disincentivised saving. This has led to consumption and investment increasing, which are components of aggregate demand. The shift in aggregate demand increases the macroeconomic equilibrium to point B, which means a higher level of real GDP than before, with an increased price level (demand-pull inflation).

Contractionary Monetary Policy: If the interest rate is increased, this will disincentivise spending. This is because there is a greater reward for saving and an increase cost of borrowing.

In the diagram above, aggregate demand has shifted to the left, due to falls in national spending. This is because the central bank has raised the interest rate. It has incentivised saving but disincentivised spending and borrowing. This has therefore reduced real GDP to Y2 and decreased the price level to P2 (ceteris paribus).

So we have seen that monetary policy is used to control the level of aggregate demand. In reality it is being used all the time to avoid a big boom-bust cycle.

In a period of economic boom, contractionary policy will probably be used.

In a period of economic recession, expansionary policy will probably be used.

How do we control the money supply?

The central bank also has control over the supply of money in the economy. When they want to try and make the economy grow they can inject more money into the economy by raising the money supply. This is called quantitative easing. It involves the creation of new money which the central bank then uses to buy financial assets such as bonds from commercial banks. Commercial banks then get hold of this money and this is how it enters the circular flow of income. The central bank can also take its money back from the commercial banks by selling its financial assets. Once the central bank receives the money back, the money is then destroyed.

When is monetary policy effective?

Monetary policy works on people responding to incentives, especially when the interest rate is changed. If confidence in the economy is high, then monetary policy will be more effective. However, if confidence is low, then monetary policy will be less effective.

Think about it, if the economy is in a huge recession, then confidence in the economy is extremely low. If the central bank cuts the interest rate, it won't mean people stop saving and start taking out huge loans! This is because people are afraid that they might lose their job, or something bad is going to happen in the economy. So people hang onto their money and save instead.

Secondly, a fall in interest rates have to be passed onto housholds by commercial banks. If the commercial banks decide not to pass on the savings, then consumers and businesses will not be affected. For monetary policy to be effective, commercial banks need to transmit the incentives made by the central bank.

Thirdly, commercial banks may not have the money to lend to people who want to borrow. So even though the interest rate is low, the comercial banks lack the money to lend. This is what happened in the credit crunch of the 2008 financial crisis. For monetary policy to be effective, commercial banks will need the money reserves to provide loans.