Monetary Policy

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.

The 4 subtopics

Each one has its own page. CCEA AS Economics students sit this topic in the first year.

• The nature of monetary policy and the interest rate instrumentMonetary policy, policy rate and inflation target symmetric rather than simply a ceiling.Open →
• The transmission mechanism from interest rates to aggregate demandHigher interest rates affect saving behaviour, investment by firms sensitive to the rate of interest and exchange rate channel of monetary policy.Open →
• Monetary policy in the AD-AS modelDifference between demand-pull and cost-push inflation and vertical long-run aggregate supply curve represent.Open →
• Evaluating the impact of monetary policy on output, employment, prices and agentsEffect of higher interest rates on firms, monetary policy described as a blunt instrument and time lags limit what monetary policy can achieve.Open →

What you need to know

Answer each one before you reveal it.

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. 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. 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. 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. 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. 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. 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.

What is inside Levo

Six ways to work the same material.

Monetary Policy revision questions

Is Monetary Policy examined at AS in CCEA Economics?

Yes. It sits in Unit AS 2, which you take in the first year, so it is on the AS paper as well as counting towards the full A level.

What does Monetary Policy cover in CCEA AS-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.