0455 · 4.3Monetary policy

Monetary policy and macroeconomic aims

0:00A café owner wants a new oven, but borrowing costs make the purchase expensive. Then the central bank lowers its interest rate. If commercial banks reduce their lending rates, that oven becomes more affordable. Across an economy, thousands of similar decisions can influence spending, jobs and prices. Monetary policy works through these connections between money and economic decisions. In this video, you will see how interest rates, the money supply and foreign exchange rates influence spending.

0:24Each measure can help a government reach aims such as low inflation and low unemployment. Improving one outcome can also create difficulties elsewhere, for example faster price rises when demand grows quickly. Macroeconomic aims are objectives for the economy as a whole. They are economic growth, full employment or low unemployment, stable prices or low inflation, balance of payments stability, redistribution of income and environmental sustainability. Economic growth is an increase in real Gross Domestic Product.

0:55Real output is measured after removing the effect of price rises. Stable prices mean keeping inflation, a sustained rise in the general price level, low and steady. Total demand means all spending on an economy’s goods and services, and it links monetary policy to these aims. When spending rises, firms have an incentive to increase production. To make the extra output, they often employ more workers. However, when businesses struggle to expand capacity, stronger demand can push prices upwards.

1:24Money supply is the total amount of money in an economy. It includes cash and money held in bank accounts that can be used for payments. Monetary policy involves changes in the interest rate, the money supply and the foreign exchange rate to influence the economy. These changes are usually made by the central bank. As the institution that manages a country’s currency, monetary policy and banking system, the central bank sets a policy interest rate.

1:47This rate influences the rates commercial banks charge borrowers and offer savers. Monetary decisions therefore affect households and firms through financial incentives. Changes in government taxation and spending belong to fiscal policy, which you will see in its separate video.

Interest rates and spending

2:02An interest rate is the cost of borrowing, or reward for saving, expressed as a percentage of the amount involved. Lower rates make borrowing cheaper, so households may finance purchases such as cars. Saving also becomes less attractive because the return falls. Together, these incentives can increase consumer spending. Firms respond through investment, which is spending on capital goods such as machinery and equipment. A firm compares the expected benefit from new equipment with its cost, including borrowing charges.

2:28Lower interest rates can make more projects worthwhile. If firms purchase additional equipment, spending rises immediately and their ability to produce may improve later. Suppose our café has a variable-rate loan of twelve thousand dollars. A variable rate can change during the loan period. After the central bank’s cut, the café’s bank lowers the loan rate from eight per cent to five per cent. Assume the balance stays the same for a year, with no fees or repayments.

2:54Annual interest equals the loan amount multiplied by the interest rate, divided by one hundred. At eight per cent, twelve thousand dollars multiplied by eight and divided by one hundred gives nine hundred and sixty dollars. After the cut, twelve thousand times five, divided by one hundred, is six hundred dollars. The yearly interest bill therefore falls by nine hundred and sixty minus six hundred, which is three hundred and sixty dollars.

3:17Those three hundred and sixty dollars leave the café with more money available for other purposes. The owner might purchase equipment, hire help or keep a financial reserve. Cheaper borrowing also makes a new investment easier to finance. The calculation shows an incentive to spend, while the owner’s final choice depends on expected sales. Across the economy, higher consumption and investment increase total demand. Where firms have unused machinery and available workers, they can expand production.

3:42This supports economic growth and reduces unemployment as employers recruit. Such measures are called expansionary monetary policy because they aim to increase total demand. Higher interest rates work through the same incentives in the opposite direction. Borrowing becomes more expensive, while saving offers a greater reward. Households may postpone purchases, and firms can abandon investment projects that have become too costly. Lower total demand reduces upward pressure on prices, so this contractionary monetary policy can help control inflation.

4:12The cost can be slower growth and higher unemployment, although spending on imports also falls.

Money supply and exchange rates

4:18The money supply provides another way to influence spending. If more money becomes available through the banking system, lending can become easier and interest rates may fall. Households and businesses then have greater opportunities to finance purchases. From there, growth and employment follow the same chain as with lower interest rates, and so does the risk of inflation. One example is quantitative easing, where a central bank buys financial assets to increase the money supply.

4:42The sellers receive money, which enters bank accounts and may support further spending or lending. Its effectiveness depends partly on how banks and their customers respond. Reducing the money supply can restrict spending and help lower inflationary pressure. The foreign exchange rate is the price of one currency expressed in another currency. Exports are goods and services sold abroad, and imports are those bought from other countries. A fall in a currency’s value against other currencies is called depreciation.

5:09Suppose sellers keep their prices in their own currency unchanged. Depreciation then makes exports cheaper for foreign buyers and imports dearer for domestic buyers. Imagine a furniture producer sells tables abroad at an unchanged price in its own currency. After depreciation, foreign customers need less of their currency to buy each table. They may order more because the tables have become cheaper for them. Domestic customers face higher prices for imported furniture, so some may switch to locally produced alternatives.

5:37Higher export sales and lower spending on imports increase demand for domestic production. Firms may then expand output and employment. The trade balance is the value of exports minus the value of imports, so it improves when export earnings rise relative to import spending. That supports the aim of balance of payments stability. The balance of payments records a country’s economic transactions with the rest of the world. Depreciation also creates a possible inflation problem.

6:03Imported fuel, materials and equipment become more expensive in domestic currency. Firms may pass those higher costs into their selling prices. A rise in the currency’s value, called appreciation, makes imports cheaper and so eases these pressures. However, it also makes exports more expensive for foreign buyers. The central bank can influence the exchange rate by buying or selling its currency in foreign exchange markets. Selling domestic currency increases its supply and puts downward pressure on its price.

6:31Higher domestic interest rates can also attract foreign savings, which increases demand for the currency and pushes its price up. Actual exchange rate movements depend on other influences too.

Trade-offs and exam technique

6:41Monetary policy measures may enable a government to achieve its macroeconomic aims, but there are trade-offs. Expansionary policy can increase output and employment when resources are available. If production cannot keep pace, stronger demand can raise inflation. Consumers may also buy more imports, which can worsen the trade balance. Redistribution of income is affected unevenly. Lower rates can benefit borrowers through smaller interest payments, while savers receive less interest income.

7:08Environmental sustainability also depends on what additional spending finances. Cheaper borrowing could support cleaner machinery, although greater production may increase pollution and resource use. Effectiveness depends strongly on confidence and timing. A business expecting weak sales may avoid borrowing even when interest rates fall. Households worried about unemployment might save extra income instead of spending it. Time lags also matter because loan agreements, investment plans and hiring decisions can take months to change.

7:37Examiners often see monetary policy answers that skip steps or mix up policies. Keep the measures to interest rates, the money supply and the exchange rate, because taxation and government spending belong to fiscal policy. Trace an interest rate change through borrowing, saving and spending before reaching output or prices. With exchange rates, decide whose currency the buyer pays in before saying which price rises. An exam question could ask you to explain how a rise in interest rates may reduce inflation.

8:02Higher rates increase the cost of borrowing, so consumers buy fewer goods on credit and firms reduce investment. Because saving earns a greater reward, households spend less of their income. With lower total demand, firms face less pressure to raise their prices. The general price level then rises more slowly, which means inflation falls. Cambridge command words tell you how far to develop each answer. Define means give a precise meaning, and state means express in clear terms.

8:29An explain answer sets out the reasons why or how an effect happens. To analyse, examine the policy in detail to show the relationships between the measure and the outcome. Discuss means writing about an issue in depth in a structured way, and it needs both sides. Take the question of whether lower interest rates will increase economic growth. Cheaper borrowing can encourage investment, while reduced saving returns stimulate consumption.

8:52Higher total demand then gives firms an incentive to increase output. However, weak confidence may prevent additional spending, and firms operating near capacity may raise prices instead of expanding production. On balance, lower interest rates usually support economic growth when confidence is reasonable and spare productive capacity exists. These conditions allow stronger demand to produce additional output. Without them, the extra demand is more likely to raise inflation than output.

9:18In multiple-choice questions, a monetary policy option names the interest rate, the money supply or the exchange rate. A lower interest rate, a larger money supply and a lower exchange rate are expansionary, because each aims to increase total demand. The opposite changes are contractionary and aim to restrain it. Follow the incentives step by step, and you can explain both the benefits of monetary policy and its limits.