Sample Notes: Monetary Policy

Notes for Topic 5.3: Monetary Policy
AS Level Economics

5.3.1 Definition of Monetary Policy

• Monetary policy refers to the use of interest rates, money supply, and credit regulation by a country’s central bank to influence aggregate demand (AD) and macroeconomic objectives like inflation, employment, and economic growth.
• The central bank (e.g., Bank of England, State Bank of Pakistan) uses these tools to:
  • Control inflation
  • Stabilise the currency
  • Achieve economic growth
  • Maintain low unemployment

5.3.2 Tools of Monetary Policy

1. Interest Rates

• The most commonly used tool.
• The base rate is set by the central bank and influences commercial banks’ lending/borrowing rates.
• Higher interest rates:
  • Increase the cost of borrowing
  • Discourage consumer and business loans
  • Reduce consumption and investment
  • Lower aggregate demand
• Lower interest rates:
  • Encourage borrowing
  • Increase consumption and investment
  • Stimulate aggregate demand

2. Money Supply

• Refers to the total quantity of money (cash + bank deposits) available in the economy.
• Central banks may control:
  • Reserve requirements (how much banks must keep in reserve)
  • Open Market Operations (buying/selling government bonds)
• Increasing money supply:
  • Encourages spending
  • May lead to inflation if not matched by output
• Decreasing money supply:
  • Slows down the economy
  • Controls inflation

3. Credit Regulations

• Central banks can impose restrictions on who can borrow and how much.
• Examples:
  • Setting credit ceilings
  • Changing loan-to-value ratios
  • Placing limits on consumer credit
• Used to prevent asset bubbles or excess consumer debt.

5.3.3 Expansionary vs Contractionary Monetary Policy

Expansionary Monetary Policy

• Aimed at stimulating economic growth.
• Tools:
  • Lower interest rates
  • Increase money supply
  • Ease credit regulations
• Effects:
  • Increases AD
  • Reduces unemployment
  • May cause inflation if overused

Contractionary Monetary Policy

• Aimed at reducing inflation or overheating of the economy.
• Tools:
  • Higher interest rates
  • Reduce money supply
  • Tighten credit access
• Effects:
  • Decreases AD
  • Lowers inflation
  • May increase unemployment or reduce growth temporarily

5.3.4 AD/AS Analysis of Monetary Policy Effects

Expansionary Monetary Policy – AD/AS Diagram Explanation

• Lower interest rates → more investment and consumption → AD shifts right (AD1 to AD2).
• Results in:
  • Higher real output
  • Lower unemployment
  • Higher price level (possible inflation)

Contractionary Monetary Policy – AD/AS Diagram Explanation

• Higher interest rates → less borrowing → AD shifts left (AD2 to AD1).
• Results in:
  • Lower real output
  • Higher unemployment
  • Lower price level (controls inflation)

Key Concepts Summary Table

Evaluation Points

• Time Lag: Interest rate changes take time to influence AD.
• Liquidity Trap: In very low interest environments, monetary policy may become ineffective.
• Consumer Confidence: Even if interest rates fall, people may not spend if confidence is low.
• Global Influences: Global interest rates, capital flows, and exchange rate changes affect effectiveness.
• Conflict with other goals: E.g., fighting inflation might hurt employment.