Explain how monetary policy might help to prevent a downturn in the economic cycle

AQA AS-Level Paper 2 June 2018 Insert

Extract B (lines 9–11) states ‘The Bank of England’s Monetary Policy Committee loosened its monetary policy in an attempt to prevent a downturn in the economic cycle.’ Explain how monetary policy might help to prevent a downturn in the economic cycle. (10 marks)

Monetary policy is the use of interest rates to influence aggregate demand in the economy. During a downturn, the Bank of England could reduce interest rates. Interest rates are the cost of borrowing and the reward for saving.

Lower interest rates can lead to an increase in consumer spending. The lower the bank rate, the lower high street interest rates should be. This means that consumers are less incentivised to save and more incentivised to borrow. Additionally, lower interest rates stimulate greater demand for houses as it is more affordable for buyers to take out a mortgage. This leads to an increase in house prices, which leads to an increase in the wealth of families who own homes. Overall, consumer confidence and therefore consumer spending should increase, causing an increase in aggregate demand, and an increase in real gdp, supporting an economic recovery,

Lower interest rates might also stimulate an increase in business investment; spending on capital goods. As businesses expect greater consumer spending, they are likely to have higher business confidence themselves. Also, as they expect to reach full capacity, they are likely to increase investment in capital. One example of this could be shops investing in more self-checkout machines. As business investment is another component of aggregate demand, this would further help the economy to recover from a downturn.

Lower interest rates can also lead to an improvement in the trade balance. As interest rates fall, there is a lower reward for saving, which means that investors would prefer to take advantage of better interest rates elsewhere. This would mean hot money flows out of the UK, which would cause the pound to depreciate. A weaker pound would make exports cheaper and imports more expensive. Therefore, the trade balance should in theory improve. As this (X-M) is another component of AD, AD would increase, causing economic growth to increase and the price level to increase.

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