Monetary Policy Tools (Cambridge (CIE) A Level Economics): Revision Note
Exam code: 9708
What is monetary policy?
Monetary policy is the use of interest rates, the money supply and credit regulations by a central bank to influence aggregate demand and achieve macroeconomic objectives
In most economies monetary policy is operated by an independent central bank rather than the government directly
In the UK this is the Bank of England; in the USA the Federal Reserve; in the Eurozone the European Central Bank
Central bank independence is considered important because it removes the temptation for governments to use monetary policy for short-term political purposes, such as cutting interest rates before an election regardless of inflationary conditions
Tools of monetary policy
1. Interest rates
The interest rate is the cost of borrowing and the reward for saving - it is the primary tool of monetary policy in most economies
The central bank sets a base rate (also called the policy rate or bank rate) which influences the interest rates charged by commercial banks throughout the economy
Changes in the interest rate affect AD through two main channels
Consumption | Investment |
|---|---|
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A fall in interest rates has the reverse effect on both channels - borrowing becomes cheaper, saving less attractive, consumption and investment rise and AD shifts right
2. Money supply
The money supply is the total stock of money in circulation in the economy, including notes and coins and bank deposits
The central bank can influence the money supply through
Open market operations | Quantitative easing (QE) |
|---|---|
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An increase in the money supply reduces interest rates, stimulating borrowing, consumption and investment - AD shifts right
A decrease in the money supply raises interest rates, reducing borrowing and spending - AD shifts left
3. Credit regulations
Credit regulations are controls on the availability and terms of borrowing
They affect how easily households and firms can access credit regardless of the interest rate level
Tools include:
Reserve requirements - the minimum proportion of deposits that commercial banks must hold in reserve rather than lend out; raising reserve requirements reduces the amount banks can lend, contracting credit
Loan-to-value ratios - limits on the size of a mortgage or loan relative to the value of an asset; tightening these reduces borrowing capacity
Lending caps - direct limits on the total volume of lending by commercial banks
Credit regulations are particularly useful when interest rates are already low and cannot be cut further, or when the central bank wants to target specific sectors such as the housing market without changing the overall interest rate
Summary of monetary policy tools
Tool | Expansionary use | Contractionary use |
|---|---|---|
Interest rates |
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Money supply |
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Credit regulations |
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Worked Example
Which combination would represent the most expansionary set of monetary policies?
Credit availability | Interest rates | Money supply | |
|---|---|---|---|
A | increased | up | reduced |
B | increased | down | increased |
C | reduced | up | increased |
D | reduced | down | reduced |
Answer: B - increased credit availability, lower interest rates, increased money supply
All three tools in option B point in the same expansionary direction - lower rates, more credit, more money. This is the combination a central bank would use during a recession to stimulate aggregate demand
Worked solution:
Each tool must be assessed against its expansionary direction:
Credit availability - increasing credit availability makes it easier for households and firms to borrow regardless of the interest rate - this is expansionary. Options C and D reduce credit availability - contractionary. This eliminates C and D immediately.
Interest rates - cutting interest rates reduces the cost of borrowing and the return on saving, stimulating consumption and investment - this is expansionary. Option A raises interest rates - contractionary. This eliminates A.
Money supply - increasing the money supply puts more money into circulation, reducing interest rates and stimulating spending - this is expansionary. Option B increases the money supply - this confirms B.
The trap is option A - it increases credit availability and increases the money supply, both expansionary, but raises interest rates which is contractionary. Two out of three tools pointing the right way is not sufficient - the question asks for the most expansionary combination, which requires all three tools working together.
Examiner Tips and Tricks
Always identify the transmission mechanism when analysing a change in monetary policy - do not simply state that cutting interest rates increases AD. The full chain is: interest rates fall - cost of borrowing falls and return on saving falls - consumption and investment rise - AD shifts right - real output, price level and employment rise.
The most commonly tested distinction is between interest rates and credit regulations - interest rates affect the cost of borrowing; credit regulations affect the availability of borrowing. Both can restrict or expand credit but through different mechanisms. A household may face low interest rates but still be unable to borrow if loan-to-value regulations are tight.
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