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 encourages 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.

Expansionary monetary policy evaluation

Liquidity trap

1. a liquidity trap occurs when monetary policy becomes ineffective because low interest rates are not stimulating any further increases in spending
2. despite low interest rates, people are choosing to save
3. this can occur because of low consumer confidence
4. low consumer confidence due to high unemployment rates discourages people from spending as freely
5. Keynesian economists would argue that expansionary fiscal policy is the best solution
6. monetarists argue that quantitative easing can be used to further increase money supply

What is quantitative easing?

1. quantitative easing is when the central bank creates money electronically
2. this money is used to buy assets such as bonds from high street banks
3. this increases money supply, making banks more willing and able to lend at a lower high street interest rate
4. this leads to increased borrowing by consumers and firms, allowing aggregate demand to increase
5. the money gets deleted when the central bank sell the assets

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.

Contractionary monetary policy evaluation

State of the economy

1. Raising interest rates may be an ineffective method to reduce the inflation rate depending on the state of the economy.
2. in a boom, consumer confidence and job security are likely to be high.
3. this means that

Current account

1. there could be a trade-off between lower inflation and another macroeconomic objective
2. contractionary monetary policy can have a negative consequence on the UK's current account
3. as interest rates increase, the reward for saving in the UK increases.
4. this means that there is a net inflow of hot money as people want to take advantage of a higher reward for their savings.
5. this leads to an increase in demand for the pound and a decrease in the supply of the pound
6. this makes exports more expensive and imports cheaper
7. this is likely to lead to a worsening of the current account deficit

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. Expansionary monetary policy evaluation
   1. liquidity trap
5. What is quantitative easing?
6. what is the impact of contractionary monetary policy on
   1. consumers
   2. businesses
   3. trade
7. Contractionary monetary policy evaluation
   1. state of the economy
   2. current account

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