Monetary Policy Transmission Mechanisms (AQA A Level Economics)

• The Central Bank has several policy actions available to use
• Depending on the severity of the economic conditions faced, they can choose to make changes to several if required

Monetary Policy Actions

Interest Rates	Exchange Rates	Money Supply	Forward Guidance
Tool for influencing borrowing, spending, and investment in the economy Adjusted by central banks through changes in the bank rate Lower rates stimulate economic activity; higher rates can cool down an overheating economy	Reflect the value of one currency relative to another Central banks can influence exchange rates by buying or selling currencies Weaker currency boosts exports; stronger currency can control inflation but may increase imports	Total amount of money circulating in an economy Controlled by central banks through open market operations such as using the required reserve requirements or quantitative easing Crucial for managing inflation, interest rates, and overall economic stability	Communication tool used by central banks to provide insight into future monetary policy intentions Aims to influence market expectations by signalling likely future actions regarding interest rates, inflation targets, or other policy measures Helps guide economic behaviour by managing expectations about future monetary policy actions

• The MPC considers how the economy is performing when adjusting the bank rate
• Their main goal is to achieve price stability
• They also consider the stage of the trade cycle and support government in achieving their macroeconomic objectives
   

Factors to Consider when Setting the Bank Rate

Factors to consider	Macroeconomic effects	Impact on Setting Bank Rate
Economic expansion	An economic expansion is associated with high levels of economic growth and low levels of unemployment This increases AD and causes inflationary pressures	Historically, when the economy was overheating, the Central Bank increased interest rates. This is known as a contractionary monetary policy  During recent periods of high inflation, interest rates have decreased or remained unchanged. This is because adjustments also consider economic growth forecasts and geopolitical uncertainty
Economic contraction	An economic contraction is associated with a recession and low levels of unemployment This decreases AD and causes deflationary pressures	Historically, when the economy is contracting, the bank has decreased its interest rate. This is known as an expansionary monetary policy   This may not always be possible, as other variables, such as high house prices, may impact interest rate adjustment

• The two main instruments of monetary policy include: 
  • Incremental adjustments to the interest rate (usually not more than 0.25%)
  • Quantitative easing which increases the supply of money in the economy
    • The Central Bank creates new money and uses it to buy open-market assets
• When a policy decision is made, it creates a ripple effect through the economy and this effect is known as a transmission mechanism

Diagram: Incremental Changes to Interest Rates

The transmission mechanisms of changes to the interest rate

Before Explaining a Mechanism from the Diagram Above, Key Terminology Can Be Reviewed Below

Official Rate	Market Rates	Asset Prices
Exchange Rate	Net External Demand	Inflation

Example 1

• Official rate decreases by 0.25% → market rates decrease → loans are cheaper → consumers borrow more → consumption increases → AD increases → inflation increases

Example 2

• Official rate decreases by 0.25% → market rates decrease → mortgages are cheaper → property buyers borrow more → demand for houses increases → asset prices increase 

Example 3

• Official rate decreases by 0.25% → market rates decrease → buyers borrow more → asset prices increase → households with assets feel wealthier → consumption increases → AD increases → inflation increases

Example 4

• Official rate increases by 0.25% → hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases → inflation decreases

Example 5

• Official rate increases by 0.25% → market rates increase → existing loan repayments now more expensive to repay → discretionary income falls → consumption decreases → AD decreases → inflation decreases

The transmission impact on exchange rates

• A change to the bank rate will have an impact on the exchange rate
  • When the exchange rate changes, there will be a ripple effect through the economy
  • This can be seen in the diagram above, where a change to the exchange rate leads to changes in the net external demand as well as the import prices
     

How Interest Rates Impact Exchange Rates

Impact of a Decrease in Interest Rates

Impact of an Increase in Interest Rates

A decrease in UK interest rates is less attractive for investors This causes capital flight as investors move their money out of the country As a result, the demand for the pound decreases, causing the exchange rate to fall UK exports will become relatively cheaper due to a weaker exchange rate Therefore, the initial rise in value of the pound may be mitigated by an increase in export sales This increase in demand is dependent on price elasticity of demand  of exports

An increase in UK interest rates is more attractive for investors This causes capital inflow as investors move their money into the country As a result, the demand for the pound increases, causing the exchange rate to rise UK exports become relatively more expensive due to a stronger exchange rate Therefore, the initial fall in value of the pound may be mitigated by a decrease in export sales This increase in demand is dependent on price elasticity of demand of exports

Is inflation too high? Increase the interest rates                     

• If the MPC wants to lower inflation, it will increase the interest rate
• This lower rate aims to reduce aggregate demand and control inflation
• Contractionary monetary policy will shift aggregate demand to the left
• The Bank of England cut the Bank Rate nine times between December 2007 & March 2009 dropping from 5.75% to 0.5%

Diagram: Keynesian Contractionary Demand-side Policies

Decrease in real GDP (YFE →Y1) and average price levels (AP1 →AP2)

Diagram analysis 

• Contractionary monetary policy will shift aggregate demand to the left (AD₁ →AD₂)
• AD shifts to the left because a higher interest rate impacts the components: Consumption (C ), Investment (I) and Exports and Imports (X − M) via the exchange rate

Consumption

• With the rise in interest rates, consumption declines as household borrowing is discouraged and savings are encouraged (C)
• The increase in interest rates on mortgages results in decreased disposable income for households
• Consumers now have less income and tend to spend less, leading to a notable decrease in aggregate demand (AD₁ →AD₂)
• This fall in aggregate demand contributes to a reduction in real GDP (Y_FE → Y₁) and average price levels (AP₁ → AP₂)

Investment 

• Investment falls as businesses borrow less due to higher interest rates
• Higher borrowing costs serve as a disincentive for businesses to undertake new investment projects
  • This reduction in business investment leads to a decline in aggregate demand in the UK economy (AD1 →AD2)
  • The contraction in aggregate demand results in a reduction in real GDP from its potential level (Y_FE) to a lower level (Y₁)
  • Additionally, the weakened demand contributes to a decrease in average price levels, transitioning from AP₁ → AP₂

Net Exports 

• A higher interest rate increases demand for the UK pound, as it offers a better return on investment, increasing capital flows into the currency
• The increased demand for the pound causes the exchange rate to rise. As a result:
  • Exports become relatively more expensive and less competitive in the global market
  • Imports become relatively cheaper and more competitive in the UK markets.
  • This worsens the UK's Balance of Payment on the current account.
• Aggregate Demand (AD) shifts to the left as a result of these economic changes, reflecting reduced overall spending in the economy

Is inflation too low? Decrease the interest rates

• If the MPC wants to encourage borrowing, it will decrease the interest rate
• This lower rate aims to stimulate aggregate demand
• This type of policy is known as a demand-side expansionary policy 

Diagram: Expansionary Demand-side Policies 

Increase in real GDP (Y1 →Y2) and average price levels (AP1 →AP2)

• Expansionary Monetary Policy will shift aggregate demand to the right (AD₂ → AD₁):
• AD Shifts to the right because lower Interest Rates Impact the Components: Consumption (C), Investment (I), and Exports and Imports (X − M) via the Exchange Rate:

Consumption

• Lower interest rates stimulate consumption as households have more disposable income.
• Increased consumer spending contributes to a rise in aggregate demand (AD₂ → AD₁)
• This increase in aggregate demand leads to an expansion in real GDP (Y₁ → Y_FE) and average price levels (AP₂ → AP₁)

Investment

• Lower interest rates make borrowing more attractive for businesses, encouraging new investment projects
  • The increase in business investment contributes to an increase in aggregate demand (AD₂ → AD₁)
  • This expansion in aggregate demand results in an increase in real GDP from its potential level (Y_FE) to a higher level (Y₁)
• Additionally, the heightened demand contributes to an increase in average price levels, transitioning from (AP₂ → AP₁)

Net Exports

• A lower interest rate reduces demand for the UK pound, as it offers a lower return on investment, leading to decreased capital flows into the currency
• The decreased demand for the pound causes the exchange rate to fall. As a result:
  • Exports become relatively cheaper and more competitive in the global market.
  • Imports become relatively more expensive and less competitive in the UK markets.
  • This improves the UK's Balance of Payment on the current account
• Aggregate Demand (AD) shifts to the right as a result of these economic changes, reflecting increased overall spending in the economy (AD₂ → AD₁)