What is monetary policy?

Monetary policy is the management of interest rates and the supply of money and credit in order to influence the level of demand in the economy, usually with the aim of keeping inflation low and stable. In practice the central instrument is the official short-term interest rate set by the central bank, which feeds through to the rates households and firms actually face. It is a demand-side policy, because it works by changing how much people choose to borrow, spend and save.

What is the policy rate, sometimes called Bank Rate, and why does it matter so much?

The policy rate is the rate the central bank sets for its own dealings with commercial banks — the rate at which it lends to them and pays on the reserves they hold with it. It matters because it anchors the whole structure of interest rates: commercial banks price their lending and savings products in relation to it, so a change passes through to mortgages, business loans and deposit rates, and from there to consumption, investment, the exchange rate and ultimately the price level.

Who sets monetary policy in the United Kingdom, and why is the decision taken by an independent committee rather than by ministers?

It is set by the Monetary Policy Committee of the Bank of England, which meets regularly and votes on the level of Bank Rate. Independence exists because politicians face an incentive to keep rates low before an election, and if households and firms expect that, they build higher inflation into wage claims and price setting. A committee that is insulated from that pressure and judged against a published target is more credible, so expectations of inflation stay anchored and the interest rate needed to control inflation is lower.

What target does a central bank such as the Bank of England pursue, and how is it defined?

It pursues a numerical inflation target, in the United Kingdom set at 2% measured by the annual change in the consumer prices index. The target is symmetric, so the central bank is required to respond to inflation that is too low as well as to inflation that is too high. Subject to meeting the target, it is also expected to support the government’s objectives for growth and employment, which is why decisions involve judgement about how quickly to bring inflation back.

Why is an inflation target symmetric rather than simply a ceiling?

Inflation that is persistently below target is itself damaging, because households may delay purchases in the expectation of lower prices later, the real burden of existing debts rises, and firms find it harder to cut real wages when the labour market needs adjusting. Very low inflation also leaves the central bank little room to cut real interest rates in the next downturn. A symmetric target therefore commits the central bank to loosen policy when inflation falls too far as well as to tighten when it rises too far.

What is the difference between loose and tight monetary policy?

Loose or expansionary monetary policy means cutting interest rates, and possibly expanding the money supply, so that borrowing becomes cheaper, saving becomes less rewarding, and aggregate demand rises. Tight or contractionary policy means raising interest rates and restricting credit so that borrowing becomes dearer, saving more attractive, and aggregate demand falls. A central bank loosens to fight weak demand and rising unemployment and tightens to fight demand-pull inflation.

CCEA A-Level Economics 4410

Key Economic Concepts

Topic overview The four factors of production Positive statements and normative judgements Economic agents and what they are trying to achieve Capital goods and consumption goods Product markets and factor markets

The Basic Economic Problem of Scarcity and Choice

Topic overview Scarcity, choice and opportunity cost Drawing and reading the production possibility frontier Using a PPF to show choice, opportunity cost, efficiency and growth Why an economy operates inside its frontier Specialisation and the division of labour Free market, planned and mixed economies

Demand and Supply in Product Markets

Topic overview What determines demand and what determines supply Movements along a curve versus shifts of a curve Why the demand curve slopes downwards Why the supply curve slopes upwards: marginal cost and the profit incentive Consumer surplus and producer surplus When consumers do not behave rationally

Markets and Equilibrium

Topic overview Market equilibrium and how markets clear How shifts in demand and supply change the equilibrium Price signals, incentives, rationing and the role of profit Joint, composite and derived demand and joint supply Tracing effects between interrelated markets Community surplus and allocative efficiency Demand and supply in housing, energy and commodity markets Indirect taxes and subsidies: impact and incidence

Elasticity of Demand and Supply

Topic overview Price elasticity of demand: measuring and interpreting Income and cross elasticity: normal, inferior, substitutes and complements Price elasticity of supply What determines the value of an elasticity Elasticity and total revenue How useful is elasticity for firms and government?

Factor Markets: Labour

Topic overview How a competitive labour market sets the wage Elasticity of labour demand and labour supply Wage differentials and why they persist Economic rent and transfer earnings Flexibility: trade unions, welfare and migration Minimum wages and government intervention in the labour market

Market Failures and Imperfections

Topic overview Market equilibrium, the social optimum and the meaning of market failure Externalities: private, external and social costs and benefits Community surplus and the externality diagrams Calculating and interpreting welfare loss Public goods, quasi-public goods and the free rider problem The consequences of missing markets for public goods Merit goods and demerit goods Information gaps and asymmetric information The consequences of merit goods, demerit goods and information failure Market power and other market imperfections Income and wealth inequality Absolute and relative poverty

Government Intervention in Markets

Topic overview Why governments step into markets Indirect taxes Subsidies, and choosing between taxes and subsidies Maximum and minimum prices State provision Regulation Information provision Tradeable pollution permits Government failure

The Circular Flow of Income

Topic overview Households, firms and the two-way flow Injections and withdrawals in an open economy with government Equilibrium and change in the circular flow

Measuring National Income

Topic overview Three routes to the same total: income, expenditure and output GDP as a measure of welfare and its limitations Domestic or national? GDP and GNP compared Nominal and real values: correcting for price changes Total and per capita measures

Aggregate Demand

Topic overview The four components of aggregate demand Why the aggregate demand curve slopes downwards Movements along and shifts in aggregate demand Factors that shift aggregate demand Investment: gross, net and fixed capital

Aggregate Supply

Topic overview Why short-run aggregate supply slopes upwards Factors that shift short-run aggregate supply Movements along and shifts in aggregate supply From the short run to the long run What determines long-run aggregate supply Keynesian and neoclassical views of long-run aggregate supply

Macroeconomic Equilibrium

Topic overview How aggregate demand and aggregate supply determine equilibrium Applying AD-AS analysis to growth and unemployment Applying AD-AS analysis to inflation

Macroeconomic Objectives

Topic overview Why governments target inflation, unemployment, the external balance and growth Objectives beyond the main four: the environment and the distribution of income and wealth Picturing inequality: the Lorenz curve and the Gini coefficient Where the objectives collide: the main policy conflicts Judging the trade-offs: how sharp is a conflict?

Inflation

Topic overview Inflation, deflation and disinflation: what the words actually mean Measuring the rate: the CPI and the RPI Working with index numbers Building a price index: the basket and the significance of weights Demand-pull and cost-push inflation The costs and consequences of inflation and deflation The policy response to inflation

Unemployment

Topic overview The claimant count and the ILO measure of unemployment Calculating and interpreting unemployment statistics Unemployment and economic inactivity: a distinction that changes the numbers The types of unemployment and what distinguishes them The causes of unemployment and of economic inactivity The costs and consequences of unemployment and inactivity Policies for unemployment and intervention in the labour market

Economic Growth

Topic overview Actual and potential growth on a production possibility frontier Measuring economic growth The economic cycle and output gaps The causes of economic growth Benefits, costs and the sustainability of growth Policies to promote economic growth using AD–AS analysis

Fiscal Policy and Its Effects

Topic overview What fiscal policy is and how it works Government spending and taxation: the main categories Direct and indirect taxation Fiscal policy in the AD-AS model Evaluating the impact of fiscal policy on output, employment, prices and agents

Monetary Policy

Topic overview The nature of monetary policy and the interest rate instrument The transmission mechanism from interest rates to aggregate demand Monetary policy in the AD-AS model Evaluating the impact of monetary policy on output, employment, prices and agents

Supply-Side Policies

Topic overview The nature of supply-side policy and tax cuts Deregulation and evaluating market-based supply-side policy Competition and innovation as supply-side policy Infrastructure as supply-side policy Labour market reform Education, training and the skills of the workforce Labour productivity: determinants and significance Supply-side policies in the AD-AS model Evaluating the impact of supply-side policies

Exchange Rates and the National Economy

Topic overview What an exchange rate is and how it is measured Exchange rate changes in the AD-AS model Holding the exchange rate above or below the market clearing level Why a government might have an exchange rate policy Evaluating the impact of exchange rate changes on output, employment, prices and agents

Short Run Versus Long Run

Topic overview The short run, the long run and the law of diminishing returns Fixed, variable and total costs of production Calculating and drawing the short-run cost curves Revenue curves: total, average and marginal revenue The profit-maximising output Shutdown, breakeven, and normal and supernormal profit Long-run cost, economies of scale and minimum efficient scale Efficiency, X inefficiency and the effects of firm size

Business Objectives

Topic overview Why firms pursue maximum profit Alternative objectives: revenue, growth, managerial utility, satisficing and the environment Ownership, control and the principal-agent problem Stakeholders, and public versus private sector objectives

Business Growth

Topic overview How and why firms grow, and why some stay small Organic growth versus merger and acquisition Horizontal, vertical and conglomerate integration Evaluating the motives for and consequences of growth

Measuring Markets

Topic overview Market size, market share and market growth The n firm concentration ratio Difficulties in measuring market share accurately Sales value against sales volume

Analysing Market Structures

Topic overview What defines a market structure Price and output across the structures Efficiency across the market structures Market structure and innovation How useful are the models of market structure?

Perfect Competition

Topic overview The price taker's revenue curves and short-run equilibrium The firm and the industry side by side How the market moves from the short run to the long run

Monopoly

Topic overview Barriers to entry Monopoly equilibrium and its consequences Price discrimination Natural monopoly Creative destruction

Monopolistic Competition

Topic overview The firm's demand curve when products are differentiated Short-run equilibrium for the firm Long-run equilibrium and excess capacity How the market moves from the short run to the long run

Oligopoly

Topic overview Concentration and interdependence: what marks out an oligopoly Collusion and price leadership Price wars and sustaining collusion Non-price competition and product differentiation The kinked demand curve model Game theory and the pay-off matrix Evaluating the costs and benefits of oligopoly

Contestable Markets

Topic overview What makes a market contestable Sunk costs and hit-and-run entry How ease of entry changes the behaviour of firms Judging contestability and its significance

Competition Policy

Topic overview The aims and shape of competition policy Breaking up firms and controlling mergers Regulation, regulators and price caps Evaluating regulation and its alternatives Taxation and subsidies as competition remedies Nationalisation Privatisation, and choosing between public and private ownership Banning unfair trading practices Judging competition policy and government failure

Trade and Globalisation

Topic overview Calculating absolute and comparative advantage Evaluating comparative advantage and its limits The gains and losses from free trade Globalisation and its effects Foreign direct investment The instruments of protectionism Evaluating protectionism The World Trade Organisation Trading blocs, trade creation and trade diversion

Economic Development

Topic overview What economic development means and how it differs from growth The difficulties of measuring development National income statistics and comparisons of living standards The Human Development Index Growth in less developed countries: benefits, costs and constraints Promoting development: aid, institutions, debt and trade

Balance of Payments

Topic overview How the balance of payments is put together Consequences of current account deficits and surpluses Policies to correct current account imbalances Expenditure-switching and expenditure-reducing policies

Exchange Rate Systems and Competitiveness

Topic overview How foreign exchange markets operate The influences on currency demand and supply Monetary policy, intervention and other influences on the exchange rate Fixed and floating exchange rate systems The Marshall-Lerner condition and the J-curve The effect of exchange rate changes on the current account Trade-weighted exchange rate indices Purchasing power parity and comparing competitiveness Evaluating exchange rate policy

European Union (EU)

Topic overview The economic case for membership of a trading bloc The costs and constraints of membership, and the position of candidate countries Enlargement, withdrawal and changes in the structure of the union The Eurozone: one currency and one interest rate

Monetary Policy and the Financial Sector

Topic overview Central banks, the banking sector and the money supply Setting the base rate and the transmission of monetary policy The Fisher equation of exchange and the quantity theory of money The financial sector and the real economy Moral hazard in banking Regulating the financial system Regulation and the money supply in a global economy Quantitative easing The money supply and monetary policy in an open economy The effectiveness of monetary policy

Fiscal Deficits and the National Debt

Topic overview The deficit and the debt: a flow and a stock What determines the size of a fiscal deficit Discretionary policy and automatic stabilisers Financing the deficit: bonds, borrowing and crowding out The benefits and costs of a deficit and of the national debt Fiscal policy, macroeconomic objectives and economic agents

Macroeconomic Policies and Objectives in a Global Economy

Topic overview Comparing the performance of different economies Global events and how they reach the domestic economy Responding to external demand and supply shocks Problems and constraints facing policymakers How the priority given to macroeconomic objectives has changed Comparing policies against one another

Quantitative Skills in Economics

Topic overview Ratios, shares and proportions in economic data Percentages and percentage changes in economic data Averages, medians and quantiles Index numbers, weighting and rebasing Converting money values to real values Cost, revenue and profit Elasticity: calculating the number and reading its meaning Choosing and reading economic charts and diagrams Interpreting economic data critically

Monetary Policy

4 subtopics
8 things to know
Unit AS 2

What Monetary Policy covers

Monetary policy is examined in Unit AS 2, Managing the National Economy. It covers the nature of monetary policy and the interest rate instrument, the transmission mechanism from interest rates to aggregate demand, monetary policy in the AD-AS model and evaluating the impact of monetary policy on output, employment, prices and agents.

Where it is assessed

Unit AS 2

Managing the National Economy, written examination, 20% of A level.

Check the CCEA specification ↗

The 4 subtopics

Each one has its own page.

What you need to know

Answer each one before you reveal it.

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Process

Describe the AD-AS diagram showing the effect of a rise in interest rates.

Key term

Why does a negative real interest rate discourage saving and encourage borrowing?

Key term

Set out the chain of events by which a rise in the central bank’s policy rate reduces aggregate demand.

Key term

Why is investment by firms sensitive to the rate of interest?

Key term

How is a cut in the central bank’s policy rate intended to raise aggregate demand?

Key term

Analyse the effect of a sustained rise in interest rates on output and employment.

Key term

Who gains and who loses among households when interest rates rise?

Key term

Analyse the effect of higher interest rates on firms.

Take Monetary Policy further

The same content, four other ways.

Commonly confused

Pairs that lose marks when they are blurred together.

The policy interest rate vs The market interest rate
The policy interest rate: what the central bank sets and charges on its own operations. The market interest rate: what banks actually charge borrowers, which moves with it but not exactly in step.
Expansionary monetary policy vs Contractionary monetary policy
Expansionary monetary policy: lowering the cost of borrowing to raise spending and output. Contractionary monetary policy: raising the cost of borrowing to slow spending and bring prices down.
The transmission mechanism vs The policy instrument
The transmission mechanism: the chain by which a rate change reaches spending, output and prices. The policy instrument: the single variable the central bank actually sets.

Questions from this topic

Each one with the model answer underneath.

1
What is monetary policy?
Model answer
Monetary policy is the management of interest rates and the supply of money and credit in order to influence the level of demand in the economy, usually with the aim of keeping inflation low and stable. In practice the central instrument is the official short-term interest rate set by the central bank, which feeds through to the rates households and firms actually face. It is a demand-side policy, because it works by changing how much people choose to borrow, spend and save.
2
What is the policy rate, sometimes called Bank Rate, and why does it matter so much?
Model answer
The policy rate is the rate the central bank sets for its own dealings with commercial banks — the rate at which it lends to them and pays on the reserves they hold with it. It matters because it anchors the whole structure of interest rates: commercial banks price their lending and savings products in relation to it, so a change passes through to mortgages, business loans and deposit rates, and from there to consumption, investment, the exchange rate and ultimately the price level.
3
Who sets monetary policy in the United Kingdom, and why is the decision taken by an independent committee rather than by ministers?
Model answer
It is set by the Monetary Policy Committee of the Bank of England, which meets regularly and votes on the level of Bank Rate. Independence exists because politicians face an incentive to keep rates low before an election, and if households and firms expect that, they build higher inflation into wage claims and price setting. A committee that is insulated from that pressure and judged against a published target is more credible, so expectations of inflation stay anchored and the interest rate needed to control inflation is lower.
4
What target does a central bank such as the Bank of England pursue, and how is it defined?
Model answer
It pursues a numerical inflation target, in the United Kingdom set at 2% measured by the annual change in the consumer prices index. The target is symmetric, so the central bank is required to respond to inflation that is too low as well as to inflation that is too high. Subject to meeting the target, it is also expected to support the government’s objectives for growth and employment, which is why decisions involve judgement about how quickly to bring inflation back.
5
Why is an inflation target symmetric rather than simply a ceiling?
Model answer
Inflation that is persistently below target is itself damaging, because households may delay purchases in the expectation of lower prices later, the real burden of existing debts rises, and firms find it harder to cut real wages when the labour market needs adjusting. Very low inflation also leaves the central bank little room to cut real interest rates in the next downturn. A symmetric target therefore commits the central bank to loosen policy when inflation falls too far as well as to tighten when it rises too far.
6
What is the difference between loose and tight monetary policy?
Model answer
Loose or expansionary monetary policy means cutting interest rates, and possibly expanding the money supply, so that borrowing becomes cheaper, saving becomes less rewarding, and aggregate demand rises. Tight or contractionary policy means raising interest rates and restricting credit so that borrowing becomes dearer, saving more attractive, and aggregate demand falls. A central bank loosens to fight weak demand and rising unemployment and tightens to fight demand-pull inflation.

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Key Economic Concepts

The Basic Economic Problem of Scarcity and Choice

Demand and Supply in Product Markets

Markets and Equilibrium

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Monetary Policy revision questions

What does Monetary Policy cover in CCEA A-Level Economics?: 4 subtopics: the nature of monetary policy and the interest rate instrument, the transmission mechanism from interest rates to aggregate demand, monetary policy in the ad-as model and evaluating the impact of monetary policy on output, employment, prices and agents. Each one has its own page with questions and model answers.
How is Monetary Policy organised?: By the CCEA 4410 specification, subtopic by subtopic, so it matches the order you are taught it in.

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