Monetary Policy | Notes

These revision notes cover everything you need to know about Monetary Policy for A-Level Economics. They're designed for students studying AQA A-Level Economics, Edexcel A-Level Economics, and Edexcel International A-Level Economics. Written by Jaisul Naik, UCL Economics graduate and A-Level Economics tutor since 2017.

What are interest rates?

Interest rates are the cost of borrowing or the reward for saving.

What is monetary policy?

Monetary policy is the use of interest rates by the central bank.

This causes a shift in aggregate demand.

What is expansionary monetary policy?

Expansionary monetary policy is when the central bank reduces interest rates.

This causes an increase in aggregate demand.

What is contractionary monetary policy?

Expansionary monetary policy is when the central bank increases interest rates.

This causes a decrease in aggregate demand.

What is the impact of lower interest rates?

Consumers

1. the cost of borrowing and reward for saving both fall.
2. this incentivises consumers to borrow and disincentivises them from saving.
3. furthermore, a fall in interest rates is likely to push house prices up.
4. this allows homeowners to benefit from more wealth, leading to an increase in consumer confidence.
5. AD = C+I+G+(X-M)
6. consumer spending is likely to increase
7. this causes an increase in aggregate demand in the economy
8. this can lead to an increase in economic growth, a decrease in unemployment, and an increase in the average price level.

Businesses

1. the cost of borrowing and reward for saving both fall.
2. this incentivises businesses to borrow and disincentivises them from saving.
3. furthermore, businesses anticipate an increase in consumer spending.
4. this encoruages them to increase investment in capital goods to meet the increase in demand.
5. this is known as the accelerator effect.
6. AD = C+I+G+(X-M)
7. since investment increases, this would lead to a further increase in aggregate demand.
8. this can lead to an increase in economic growth, a decrease in unemployment, and an increase in the average price level.

Trade

1. interest rates are the reward for saving
2. people in the UK would sell the pound and buy another currency where they can get the highest return on their savings.
3. this means that there are hot money flows out
4. this means that there is an increase in supply of the pound
5. this means that the value of the pound would depreciate
6. this causes exports to become more cheaper and imports to become more expensive.
7. this leads to an improvement in the trade balance (X-M)
8. this causes an increase in aggregate demand in the economy
9. this can lead to an increase in economic growth, a decrease in unemployment, and an increase in the average price level.

What is the impact of higher interest rates?

Consumers

1. the cost of borrowing and reward for saving both fall.
2. this incentivises consumers to borrow and disincentivises them from saving.
3. furthermore, a fall in interest rates is likely to push house prices up.
4. this allows homeowners to benefit from more wealth, leading to an increase in consumer confidence.
5. AD = C+I+G+(X-M)
6. consumer spending is likely to increase
7. this causes an increase aggregate demand in the economy
8. this can lead to an increase in economic growth, a decrease in unemployment, and an increase in the average price level.

Businesses

1. the cost of borrowing and reward for saving both fall.
2. this incentivises businesses to borrow and disincentivises them from saving.
3. furthermore, businesses anticipate an increase in consumer spending.
4. this encoruages them to increase investment in capital goods to meet the increase in demand.
5. this is known as the accelerator effect.
6. AD = C+I+G+(X-M)
7. since investment increases, this would lead to a further increase in aggregate demand.
8. this can lead to an increase in economic growth, a decrease in unemployment, and an increase in the average price level.

Trade

1. interest rates are the cost of borrowing or reward for saving
2. higher interest rates incentivises people to buy the pound as they can get a higher return on their savings
3. this is called hot money flows into the UK.
4. as there is an increase in demand for the pound, the value of the pound would increase.
5. this causes exports to become more expensive and imports to become cheaper.
6. this leads to an improvement in the trade balance (X-M)
7. this causes an increase aggregate demand in the economy
8. this can lead to an increase in economic growth, a decrease in unemployment, and an increase in the average price level.

Summary questions

1. what is monetary policy?
2. what are interest rates?
3. what is the impact of expansionary monetary policy on
   1. consumers
   2. businesses
   3. trade
4. what is the impact of contractionary monetary policy on
   1. consumers
   2. businesses
   3. trade

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