Explain how expansionary monetary policy could be used to close a deflationary (recessionary) gap.

Evaluate the effectiveness of monetary policy in reducing an economy’s rate of inflation.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definitions of monetary policy, expansionary monetary policy, deflationary gap
• diagrams to show a deflationary gap and how it would be closed by a shift of AD to the right and/or increasing money supply that leads to decrease in the interest rates 
• explanation that by increasing the money supply/decreasing the interest rate the central bank stimulates consumption, investment and/or net export, leading to an increase in AD and return of the real GDP to its potential level
• examples of countries that have used expansionary monetary policy to close a deflationary gap.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part B.

Answers may include:

• definitions of monetary policy, inflation
• diagram to show AD shifting left as a result of contractionary monetary policy
• explanation of how contractionary monetary policy may help to reduce demand-pull inflation in terms of the mechanisms by which higher interest rates reduce AD via the effect on consumption, investment and/or net exports 
• examples of contractionary monetary policy being used in practice or examples of inflation targeting 
• synthesis or evaluation.

Evaluation may include: the implications of monetary policy in terms of the ability to implement changes in interest rates relatively quickly through the banking system, the possible conflicts with other objectives of economic policy, such as growth / unemployment, time lags, the independence of the central bank; the ineffectiveness of monetary policy in relation to cost-push inflation; the possibility that alternative policies (e.g. supply-side policies) may be more effective.

Many students showed a good understanding of expansionary monetary policy and the deflationary gap and clearly explained how reducing interest rates can lead to an increase in aggregate demand and close a deflationary gap. These answers were illustrated by effective aggregate demand and supply diagrams and in some cases real-world examples. Although, as was said earlier, students do find using examples with macroeconomic questions challenging.   

This question also produced many good responses from candidates. The best answers showed a clear understanding of how contractionary monetary policy reduces aggregate demand and leads to a fall in demand-pull inflation. These responses were well illustrated by aggregate demand and supply diagrams. Finding a real-world example to support their answers proved quite challenging for students, although there were some effective points about countries using monetary policy to control inflationary pressures. It was good to see candidates evaluating their answers by considering the deflationary threat of increasing interest rates and a possible rise in unemployment, along with the problem of using contractionary monetary policy to deal with cost-push inflation. The best answers often included discussion of other policy options to reduce inflation such as fiscal policy and supply-side policies.