Monetary Policy Measures (CIE IGCSE Economics)

• Monetary policy involves adjusting the money supply so as to influence total (aggregate) demand
  • The money supply is the amount of money in an economy at any given moment in time
  • It consists of coins, banknotes, bank deposits & central bank reserves
     
• The Central Bank in each economy is responsible for setting monetary policy
  • • The Bank's Monetary Policy Committee usually meets 4-8 times a year to set policy
       

The Three Main Instruments of Monetary Policy

1. Interest Rates: Incremental adjustments to the interest rate (usually not more than 0.25%)
2. Quantitative easing (QE):  Increases the supply of money in the economy. The Central Bank creates new money & uses it to buy open-market assets such as bonds. When they buy the bond back early, there is an injection of new money into the economy (investors get their money back & can now spend it)
3. Exchange Rates: Adjustments to the exchange rate. The Central Bank is able to influence the exchange rate through buying or selling its own currency. This in turn influences the level of exports/imports
   
   

• 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 
     
• 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

• When a policy decision is made, it creates a ripple effect through the economy impacting the macroeconomic objectives of the government
  
  
• To understand the effects of monetary policy on an economy, it is useful to know how total demand (gross domestic product) is calculated
  
  
• Total (aggregate) demand = household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
  • • Total demand = C + I + G + (X - M)
       
• From this, it is logical that changes to monetary policy can influence any of these components - & often several of them at once
   

Examples of The Impact of Contractionary Monetary Policy

Example 1	The Central Bank increases interest rates
Effect on the economy	Existing loan repayments for households become more expensive → discretionary income reduces → consumption decreases → total demand falls Firms are less likely to borrow  → less investment in capital takes place → total demand falls Hot money flows increase → the exchange rate appreciates → exports more expensive & imports cheaper → net exports reduce → total demand decreases
Impact on macroeconomic aims	Economic growth slows down Inflation eases Unemployment may increase as output is falling & fewer workers are required Current Account is likely to worsen as both exports & imports reduce (exports more expensive & imports cheaper - but households have less income for imports)

   

Examples of The Impact of Expansionary Monetary Policy

Example 1	The USA Federal Reserve Bank commits to $60bn a month of QE
Effect on the economy	Commercial banks receive cash for their bonds → liquidity in the market increases → commercial banks lower lending rates → consumers & firms borrow more → consumption & investment increase → total demand increases
Impact on macroeconomic aims	Economic growth increases Inflation rises Unemployment may fall as output is increasing & more workers are required Current Account worsens (with more income, imports may rise)

   

Strengths of Monetary Policy

• The Bank of England operates independently from the Government (political process)
• Is able to consider the long-term outlook
• Targets inflation & maintains stable prices
• Depreciating the currency can increase exports

Weaknesses of Monetary Policy

• Conflicting goals e.g economic growth caused by lower rates puts upward pressure on inflation
• Time lags between policy & the desired impact (up to 2 years)
• Firms & consumers may not respond to lower interest rates when confidence is low
• Cheaper loans may inflate asset prices (e.g. property) in the long term
• The interest rate has limitations on downward adjustment - the closer the rate gets to zero, the less effective