Central Banks & Monetary Policy (AQA A Level Economics)

• A central bank is the government's bank that issues currency and controls the supply of money in the economy
• Central banks play a vital role in maintaining stability in the financial system
• The policy tools at their disposal help to meet government macroeconomic objectives 

Diagram: Role of the Central Bank

Central Banks play four important roles in the economy

1. Banker to the government: The government sets the annual budget, but it is the Central Bank that manages the tax receipts and payments. In 2022, there were 5.7 million public sector workers in the UK who had to be paid each month

2. Banker to the banks—lender of last resort: Commercial banks are able to borrow from the Central Bank if they run into short-term liquidity issues. Without this help, they might go bankrupt, leading to instability in the financial system  and a potential loss of savings for many households

3. Regulation of the banking industry: The high level of asymmetric information in financial markets, it requires that commercial banks be regulated in order to protect consumers. One of the key regulatory actions to manage the money supply and promote stability in the financial system is the implementation of required reserve ratios.. Raising the ratio decreases the money supply in the economy, and vice versa

4. Implementation of monetary policy: This involves the Central Bank taking action to influence interest rates, the money supply, credit and the exchange rate 

• Monetary policy is used to help the government achieve their macroeconomic objectives

• Specifically, the use of monetary policy aims to achieve
  • A low and stable rate of inflation
  • Low unemployment
  • Reduce trade/economic cycle fluctuations
  • Promote a stable economic environment for long-term growth
  • To control the level of exports and imports (net external balance)

• When a policy decision is made, it creates a ripple effect through the economy, impacting the macroeconomic objectives of the government

• The Monetary Policy Committee (MPC) under the Bank of England (UK Central Bank) is responsible for setting monetary policy
  • They meets eight times a year to set policy and consist of nine members
  • The single most important consideration in their deliberations is the inflation target of 2% CPI
  • At this meeting, they set the bank rate and discuss if quantitative easing is required
  • Policy is decided by majority vote
  • It can take up to two years for the full effects of decisions to be seen in the economy

Expansionary Monetary Policy

• Monetary policy can be expansionary in order to generate further economic growth (also referred to as loose monetary policy)
  • Expansionary policies include reducing interest rates, increasing QE, or depreciating the exchange rate 
       
• To understand the effects of monetary policy on an economy, it is useful to know how aggregate demand (AD) is calculated
  • AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
  • AD = C + I + G + (X - M)
     
• From this, it is logical that changes to monetary policy can influence any of these components - and often several of them at once
    
• Expansionary monetary policy aims to shift aggregate demand (AD) to the right

Diagram: Expansionary Monetary Policy

AD/AS diagram illustrating expansionary monetary policy which increases real GDP (Y₁ →Y₂) and average price levels (AP₁ →AP₂) 

Diagram analysis

• The economy is initially in macroeconomic equilibrium AP₁Y₁
• The Central Bank wants to boost economic growth and lower interest rates
• Lower interest rates cause investment and consumption to increase, which are components of AD
• Aggregate demand increases from AD₁→ AD₂
• The economy reaches a new equilibrium at AP₂Y₂ - a higher average price level and a greater level of national output
  
  

An Example of how Expansionary Monetary Policy Impacts on the Goals

Contractionary Monetary Policy

• Monetary policy can be contractionary in order to slow down economic growth or reduce inflation (also referred to as tight monetary policy)
  • Contractionary policies include increasing interest rates, decreasing/stopping QE, or appreciating the exchange rate
      

• Contractionary monetary policy aims to shift aggregate demand to the left

Diagram: Contractionary Monetary Policy

Keynesian diagram illustrating contractionary monetary policy which decreases the real GDP (Y_FE →Y₁) and average price levels (AP₁ →AP₂) 

Diagram analysis

• The economy is initially in macroeconomic equilibrium AP₁Y_FE
• The Central Bank is wanting to lower inflation towards its target of 2% - and increases interest rates
• Higher interest rates cause investment and consumption to decrease
• Aggregate demand decreases from AD₁→ AD₂
• The economy reaches a new equilibrium at AP₂Y₁ - a lower average price level and a smaller level of national output

An Example of how Contractionary Monetary Policy Impacts on the Goals