.png)
Topic 3.6
Monetary Policy
In this topic, you will learn about monetary policy and how it can be used to achieve price stability, through the use of interest rates and quantitative easing.
What is Monetary Policy?
Monetary Policy
Monetary policy is the control of an economy's money supply and interest rates by the central bank to achieve the main economic objectives, but mainly price stability. It is always controlled by the central bank, not the government. Monetary policy involves changing the interest rates and also the money supply in an economy, through quantitative easing (QE) and quantitative tightening (QT).
Contractionary Monetary Policy
Contractionary monetary policy is the use of quantitative tightening and raised interest rates to achieve price stability. The raised interest rates make borrowing more expensive which reduces consumption and shifts AD left, which cools inflation.
Expansionary Monetary Policy
Contractionary monetary policy is the use of quantitative easing and lowered interest rates. Lower interest rates mean that borrowing is less expensive so consumption increases. It also means that more private sector investment (both domestic and foreign) increases.
Quantitative Easing vs Quantitative Tightening
Expansionary
Quantitative Easing (QE)
Quantitative Easing is when the Bank of England creates money electronically and then buys financial assets (mainly government bonds) from commercial banks, which injects liquidity and money into the economy. This is a 'last-ditch' resort when interest rates are near zero - QE causes a lot of inflation.
Contractionary
Quantitative Tightening (QT)
Quantitative Tightening is a contractionary monetary policy used by central banks to decrease the amount of liquidity or money supply in the economy. This is typically achieved by selling government bonds or letting them mature and removing them from the bank's balance sheet. QT is often implemented to combat rising inflation and cool down an overheating economy by effectively increasing market interest rates.
Hot Money Inflow and the Positive Wealth Effect
Hot Money Inflow
Hot money inflow occurs when international investors move their capital into an economy to take advantage of higher interest rates. This increase in demand for the currency leads to appreciation, affecting the balance of payments and domestic monetary stability.
Positive Wealth Effect
The positive wealth effect happens when an increase in asset prices, such as houses or stocks, makes individuals feel wealthier. Lowered interest rates also cause the positive wealth effect. Borrowing costs fall so it becomes more attractive to buy assets such as housing, increasing the asset prices. This leads to higher consumer confidence and increased spending, which shifts the aggregate demand curve to the right.
Evaluating the use of monetary policy
Points
Evaluations
-
When interest rates are raised:
-
Less inflation
-
Hot money inflow so more demand for currency so currency appreciates - associated benefits of appreciation (cheaper imports/more expensive exports)
-
-
When interest rates fall:
-
Positive wealth effect
-
Economic growth (eval = fiscal policy is much more effective)
-
Hot money outflow so supply of currency increases so currency depreciates - associated benefits of depreciation (less imports/more exports)
-
-
Investment might not increase due to confidence in the economy as producers might choose to save or spend on dividends for shareholders
-
Quantitative Easing causes a lot of inflation
-
Negative wealth effect when interest rates are risen
-
Depends on Marginal Propensity to Consume and Marginal Propensity to Save (topic 4.3)
💡
Key Tip: This 6-marker is much easier once you have completed topic 4.3 as interest rates are heavily linked to exchange rates, so understanding the link will give you more points to use in this topic.