3.5.1 An Overview of Monetary Policy

• Demand-side policies aim to shift aggregate demand (AD) in an economy
   
• There are two categories of demand-side policies
  • Fiscal policy and monetary policy
    
    
• Fiscal policy involves the use of government spending and taxation to influence AD
  • The government is responsible for setting fiscal policy
  • Governments usually present their fiscal policies to the country each year when they deliver the Government budget
    
    
• Monetary policy involves adjusting interest rates and the money supply so as to influence AD
  • Central Banks are usually responsible for setting monetary policy
  • Central Bank committees usually meet 4-8 times a year to set policy

• Monetary policy is used to help the government achieve their macroeconomic objectives
• Specifically, the use of monetary policy aims to achieve
  • A low and stable rate of inflation
  • Low unemployment
  • Reduce business cycle fluctuations
  • Promote a stable economic environment for long-term growth
  • To control the level of exports and imports (net external balance)

• When a policy decision is made, it creates a ripple effect through the economy impacting the macroeconomic objectives of the government

• In economics, the use of the word nominal refers to the fact that the metric has not been adjusted for inflation
   
• The nominal interest rate is the headline rate presented by commercial banks
  • There has been no adjustment to the interest rate based on the rate of inflation
    
    
• The real interest rate is the nominal interest rate minus the rate of inflation
  • For example, if the nominal interest rate for saving money at a commercial bank is 3% and inflation is 2% then the real interest rate is 1%
  • The value of the savings is effectively increasing by only 1%
     
• The real interest rate can also be calculated using consumer price index (CPI) data

Step 1: Calculate the inflation rate by calculating the % difference between the CPI for 2021 and 2020

Step 2: Calculate the real interest rate

Real interest rate = nominal interest rate - inflation rate

          = 4% - 2.62%

                = 1.38%
 

(3 marks for a correct answer or 1 mark for any correct working)

• The two main instruments of monetary policy include
  • Incremental adjustments to the interest rate (usually not more than 0.25%)
  • Quantitative easing which increases the supply of money in the economy
    • The Central Bank creates new money and uses it to buy open-market assets such as bonds
      
      
• When a policy decision is made, it creates a ripple effect through the economy and this effect is known as a transmission mechanism
   

Incremental Changes to Interest Rates

The transmission mechanisms of changes to the interest rate

Before Explaining a Mechanism from the Diagram Above, key Terminology can be Reviewed Below

Example 1

• Official rate decreases by 0.25% → market rates decrease → loans are cheaper → consumers borrow more → consumption increases → AD increases → inflation increases
  
  

Example 2

• Official rate decreases by 0.25% → market rates decrease → mortgages are cheaper → property buyers borrow more → demand for houses increases → asset prices increase 
  
  

Example 3

• Official rate decreases by 0.25% → market rates decrease → buyers borrow more → asset prices increase → households with assets feel wealthier → consumption increases → AD increases → inflation increases

Example 4

• Official rate increases by 0.25% → hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases → inflation decreases

Example 5

• Official rate increases by 0.25% → market rates increase → existing loan repayments now more expensive to repay → discretionary income falls → consumption decreases → AD decreases → inflation decreases

 
Quantitative Easing Transmission Mechanism

• The Bank of England commits to buy £60bn of gilts a month → commercial banks receive cash for their gilts → liquidity in the market increases → commercial banks lower lending rates → consumers and firms borrow more → consumption and investment increase → AD increases → inflation increases

Expansionary Monetary Policy

• Monetary policy can be expansionary in order to generate further economic growth (also referred to as loose monetary policy)
  • Expansionary policies include reducing interest rates, increasing QE, or depreciating the exchange rate 
       
• To understand the effects of monetary policy on an economy, it is useful to know how aggregate demand (AD) is calculated
  • AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
  • AD = C + I + G + (X - M)
     
• From this, it is logical that changes to monetary policy can influence any of these components - and often several of them at once
    
• Expansionary monetary policy aims to shift aggregate demand (AD) to the right
   

Classical diagram illustrating expansionary monetary policy which increases real GDP (Y₁ →Y₂) and average price levels (AP₁ →AP₂)
 

Diagram Analysis

• The economy is initially in macroeconomic equilibrium AP₁Y₁
• The Central Bank is wanting to boost economic growth and lowers interest rates
• Lower interest rates cause investment and consumption to increase which are components of AD
• Aggregate demand increases from AD₁→ AD₂
• The economy reaches a new equilibrium at AP₂Y₂ - a higher average price level and a greater level of national output
  
  

An Example of how Expansionary Monetary Policy Impacts on the Goals

Contractionary Monetary Policy

• Monetary policy can be contractionary in order to slow down economic growth or reduce inflation (also referred to as tight monetary policy)
  • Contractionary policies include increasing interest rates, decreasing/stopping QE, or appreciating the exchange rate
      

• Contractionary monetary policy aims to shift aggregate demand to the left
  
  

Keynesian diagram illustrating contractionary monetary policy which decreases the real GDP (Y_FE →Y₁) and average price levels (AP₁ →AP₂)
 

Diagram Analysis

• The economy is initially in macroeconomic equilibrium AP₁Y_FE
• The Central Bank is wanting to lower inflation towards its target of 2% - and increases interest rates
• Higher interest rates cause investment and consumption to decrease
• Aggregate demand decreases from AD₁→ AD₂
• The economy reaches a new equilibrium at AP₂Y₁ - a lower average price level and a smaller level of national output

An Example of how Contractionary Monetary Policy Impacts on the Goals

Strengths of Monetary Policy

• Central Banks can operate independently from the Government (political process)
  • Central Banks can consider the long-term outlook
• Contractionary policy is often effective when there is an inflationary gap
  • Targets inflation and maintains stable prices
• Depreciating the currency can increase exports
• The frequency of policy alterations (4-8 times per year) allows for constant adjustments to macroeconomic variables

Weaknesses of Monetary Policy

• Conflicting goals e.g economic growth puts upward pressure on inflation
• Expansionary policy is less effective during a deflationary gap
  • The larger the output gap the less effective it can be 
  • Consumers may not respond to lower interest rates when confidence is low
• Time lags between policy and the desired impact (up to 2 years)
  • During particularly bad recessions, the impact of expansionary policy may take some time to be seen in the economy
• Expansionary policy leads to cheaper credit which can inflate asset prices (houses) in the long term
• The interest rate has limitations on downward adjustment
  • The closer it gets to zero the less effective changes are