A committee of about nine people meets eight times a year and changes one number. That number is not a tax, not a budget, and not a law, yet it moves mortgage payments, business investment, the exchange rate and eventually the price of almost everything. Monetary policy is the most powerful lever in macroeconomics operated by people nobody elected, and understanding why it is arranged that way is half of understanding the topic.
Monetary policy
The use of interest rates, the money supply and sometimes the exchange rate by a central bank to influence the level of economic activity and achieve macroeconomic aims.
The commonest lost mark here is attributing monetary policy to the government. It is conducted by the central bank, and in most countries the central bank is operationally independent of the government precisely so that it is not. Fiscal policy is the government's; monetary policy is the central bank's. Getting that wrong in the first line undermines everything after it.
The instruments
There are three instruments and the syllabus expects all of them. The interest rate is the main one: the central bank sets a policy rate, and commercial banks move their own lending and saving rates with it. The money supply can be changed directly, by buying or selling government bonds, which puts money into or takes it out of the banking system. And the exchange rate can be influenced, since buying or selling the domestic currency changes its value and therefore the price of imports and exports. In practice the interest rate does most of the work, but an answer naming only one instrument has answered a third of the question.
Expansionary monetary policy means cutting the interest rate or increasing the money supply. Borrowing becomes cheaper, saving less rewarding, and total demand rises. It is used when growth is weak and unemployment is rising. Contractionary monetary policy means raising the interest rate or reducing the money supply, which dampens borrowing and spending. It is used when inflation is climbing. The direction follows the problem, exactly as with fiscal policy.
A change in the interest rate reaches ordinary households through several routes at once. Mortgage and loan repayments rise or fall, which changes how much income is left to spend. Saving becomes more or less attractive, which changes how much is set aside rather than spent. Borrowing to buy cars, furniture and other durable goods becomes cheaper or dearer. Firms feel it too: a project that was worth borrowing for at 3% may not be at 6%, so investment plans are shelved. Households with large mortgages and firms that borrow heavily feel it most, which is one reason the effects are uneven.
Explain questions on interest rates are marked on the linking, not on the list. 'Interest rates rise so demand falls' is one mark at best. 'Interest rates rise, so mortgage repayments increase, so households have less disposable income, so consumption falls, so aggregate demand falls' is the same idea earning four times as much. Name each step.
Nominal and real interest rates
Real interest rate = nominal interest rate - rate of inflationThis is the approximation, and it is the one Cambridge expects. The exact relationship is (1 + nominal) / (1 + inflation) - 1, which matters only at high inflation rates. Formulae are not printed in any 9708 paper, so recall it.
Working out whether a saver is actually gaining
A bank pays savers a nominal interest rate of 3.5% a year. Inflation over the same year is 5.1%. Calculate the real interest rate and explain what it means for the saver.
Which of the following is an instrument of monetary policy?
A central bank raises interest rates. Other things being equal, the most likely effect on the exchange rate is:
Draw a demand and supply diagram for loanable funds, or for money, showing the interest rate on the vertical axis. Show the effect of the central bank increasing the money supply, and mark the new equilibrium interest rate.
The point of the diagram is that the central bank cannot set the interest rate and the money supply independently. Increasing the supply of money pushes the equilibrium interest rate down; targeting a lower interest rate requires supplying more money. Choosing one determines the other, which is a distinction examiners reward at AS and above.