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ExamPass · IGCSE worksheet

Monetary policy

NameClassDate

Key terms

Define each term.

1
Monetary policy
2
Money supply

Multiple choice

Circle the correct answer.

3

Which of the following is an instrument of monetary policy?

  1. A rise in the rate of value added tax
  2. An increase in spending on new hospitals
  3. A cut in the central bank's policy interest rate
  4. A reduction in the state pension
4

A central bank raises interest rates. Other things being equal, the most likely effect on the exchange rate is:

  1. The currency depreciates, because exports become dearer
  2. The currency appreciates, because higher returns attract financial inflows
  3. No effect, since interest rates and exchange rates are unrelated
  4. The currency appreciates, because imports become cheaper

Worked problems

Show your working.

5

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.

Diagrams

6

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.

Answers

1

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.

2

Money supply: The total amount of money in an economy at a given time, including notes and coins and money held in bank accounts.

3

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.

4

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.

5

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.

6

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.