Monetary policy
Key terms
Define each term.
Multiple choice
Circle the correct answer.
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:
Why does an independent central bank with a published inflation target tend to achieve lower inflation than a government setting rates directly?
Worked problems
Show your working.
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.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How a rate rise reduces demand-pull inflation
- A The central bank raises its policy rate in response to inflation above target.
- B Higher domestic rates attract financial inflows, demand for the currency rises and it appreciates.
- C Commercial banks raise lending and deposit rates, since their own cost of funds has risen.
- D Borrowing becomes more expensive and saving more rewarding, so households postpone consumption, particularly of durables bought on credit.
- E Appreciation makes exports dearer abroad and imports cheaper at home, so net exports fall.
- F Consumption, investment and net exports have all fallen, so aggregate demand shifts left.
- G The price level rises more slowly, so the inflation rate falls, at the cost of lower output and higher unemployment in the short run.
- H Firms face a higher cost of capital, so marginal investment projects no longer clear their required rate of return and investment falls.
Diagrams
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.
Draw an AD/AS diagram for an economy experiencing demand-pull inflation with AS steepening near full capacity. Show the effect of contractionary monetary policy on AD, the price level and real output. Then draw the same shift on an economy in deep recession where AS is flat.
Answers
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.
Money supply: The total amount of money in an economy at a given time, including notes and coins and money held in bank accounts.
C. The other three are all changes to government spending or taxation, which makes them fiscal policy. Only the interest rate is set by the central bank and is therefore a monetary instrument.
B. Higher domestic interest rates make deposits in that currency more attractive to foreign investors, so demand for the currency rises and it appreciates. The appreciation then makes imports cheaper and exports dearer, which is a separate consequence rather than the cause.
B. The gain is credibility rather than competence. If firms and workers believe inflation will be held near target, they set prices and wages accordingly, and that expectation is partly self-fulfilling. A government that might loosen policy before an election cannot make the same promise believably.
Step 1. Apply the real interest rate relationship. Real interest rate = nominal interest rate - rate of inflation = 3.5% - 5.1%.
Step 2. Complete the subtraction, keeping the sign. 3.5 - 5.1 = -1.6%. The real interest rate is negative.
Step 3. Interpret it. The saver's balance grows by 3.5% over the year, but the prices of the things they want to buy rise by 5.1%. The money in the account buys 1.6% less at the end of the year than at the start, so the saver has lost purchasing power despite receiving interest.
Step 4. Draw the wider consequence. A negative real interest rate rewards borrowing and penalises saving, because the real value of a debt is being eroded at the same time. This is why the real rate, not the nominal rate, determines behaviour.
Candidates lose marks by dropping the minus sign or by answering that the saver has gained because they received interest. Always state whether the real rate is positive or negative and say what that means for purchasing power.
A, C, D, H, B, E, F, G
- The central bank raises its policy rate in response to inflation above target.
- Commercial banks raise lending and deposit rates, since their own cost of funds has risen.
- Borrowing becomes more expensive and saving more rewarding, so households postpone consumption, particularly of durables bought on credit.
- Firms face a higher cost of capital, so marginal investment projects no longer clear their required rate of return and investment falls.
- Higher domestic rates attract financial inflows, demand for the currency rises and it appreciates.
- Appreciation makes exports dearer abroad and imports cheaper at home, so net exports fall.
- Consumption, investment and net exports have all fallen, so aggregate demand shifts left.
- The price level rises more slowly, so the inflation rate falls, at the cost of lower output and higher unemployment in the short run.
AO2 analysis is 40% of the written papers. Note that three separate AD components move here, and the exchange rate channel is the one candidates most often omit. Including it is a cheap way to lift an answer.
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.
Drawing both is the point. Near capacity the leftward AD shift lands mostly on the price level, which is the policy working as intended. In deep recession the same shift costs a great deal of output for very little price effect. The state of the economy determines whether the policy is well judged, and saying so explicitly is worth marks.