In the following video you’ll learn about one of the demand-management approaches to
the economy.
We’ll explore what monetary policy is and how it works.
Before we discuss monetary policy, let’s first establish what is meant by a central
bank.
I’ll use the definition provided by the European Central Bank.
A central bank is a public institution that manages the currency of a country or group
of countries and controls the money supply – literally, the amount of money in circulation.
The main objective of many central banks is price stability.
In some countries, central banks are also required by law to act in support of full
employment.
We’ll use the definition provided here as our basis.
However, the focus will be on a singular country’s central bank as opposed to a group of nations.
Monetary policy is the central bank’s use of changes in interest rates, the money supply
and the exchange rate in order to influence the level of aggregate demand within an economy.
I’ll now explain each of the monetary policy tools and how they can be used to influence
the economy.
You’ll need a general overview at AS but will have to understand how the tools work
in greater depth at A2.
First up, interest rates.
The most basic definition of the interest rate is the cost of borrowing and the reward
for saving.
Consumers, businesses and government all factor in interest rates in some of their decisions.
Consider the following scenarios.
Would you rather borrow money at 15% or 1%?
Would you rather save money at 15% or 1%?
It’s likely you would prefer to borrow money at 1% and save at 15%.
We’ll factor this into our discussion next.
Lower interest rates encourage consumption and investment because the cost of borrowing
is lower.
Loan repayments are more affordable and therefore people are more likely to borrow to buy homes,
cars and other items purchased on credit.
Businesses are more likely to borrow to expand production.
With a lower interest rate, saving becomes less attractive so people are inclined to
spend.
Lower interest rates can therefore be said to boost aggregate demand by encouraging spending
and discouraging saving.
Higher interest rates discourage consumption and investment because the cost of borrowing
is higher.
Loan repayments are more expensive and therefore people are less likely to borrow to buy homes,
cars and other items purchased on credit.
Businesses are less likely to borrow to expand production.
With a higher interest rate, saving becomes more attractive so people are inclined to
save.
Higher interest rates can therefore be said to decrease aggregate demand by discouraging
spending and encouraging saving.
Now let’s look at the money supply.
The money supply is the total stock of money circulating in an economy at a given time.
It not only includes cash and coins but also deposits and various other money accounts
as well.
For the sake of this discussion, we’ll focus on the money supply as it relates to the money
that banks have available to lend.
When the central bank increases the money supply there is more money available for banks
to lend.
With more money to lend, they can offer it at lower interest rates.
This should result in increased consumption and investment as explained before.
When the central bank decreases the money supply there is less money available for banks
to lend.
With less money to lend, there is more competition amongst borrowers for the funds.
This drives up the interest rate and makes it more expensive to borrow.
This higher interest rate will result in decreased consumption and investment as explained earlier.
Finally, we’ll consider exchange rates.
The exchange rate is the cost of the domestic currency with respect to other currencies.
In an earlier video we covered the different exchange rate systems and depending on which
system they operate, manipulating the exchange rate can be easier or more difficult.
Part of monetary policy is determining the exchange rate system.
There also exists a relationship between interest rates and exchange rates, which I’ll now
explain.
This is the process by which higher interest rates result in a strengthening of the domestic
currency.
I’ll use the example of the British pound to illustrate.
As British banks offer higher interest rates to depositors, UK banks attract more depositors
- both domestic and foreign.
However, for foreign depositors to keep their money in British banks, it must be converted
into pounds.
This will increase the demand for pounds and cause the pound to appreciate on the foreign
exchange market.
A strong pound will make British exports relatively more expensive to foreign buyers and potentially
decrease the value of net export revenue, resulting in decreased aggregate demand.
It is important to remember that this effect can be offset by inflation and the perceived
stability of the country’s monetary system.
A more stable economy and government is more likely to attract depositors when interest
rates rise.
We’ll next examine expansionary vs contractionary monetary policy.
Expansionary monetary policy is policy aimed at increasing the level of aggregate demand
within an economy.
This could be done to reflate the economy by decreasing interest rates, increasing the
money supply or weakening the international value of the currency.
These actions in turn could increase consumption and investment and also make exports relatively
cheaper to foreign buyers.
Inflation would be an acceptable tradeoff at a time like this.
Consider the following position of the economy.
If real GDP is currently at Y* and the price level is at PL*, we are far away from our
full employment level of output.
The central bank could enact expansionary monetary policy, by decreasing interest rates,
increasing the money supply, weakening the international value of the currency or a combination
with hopes of increasing AD from AD to AD1.
This, in turn, would increase real GDP to Y1 with an acceptable trade off of the increasing
price level from PL* to PL1. Real GDP rises, the price level rises and unemployment falls.
Contractionary monetary policy is policy aimed at decreasing the level of aggregate demand
within an economy by increasing interest rates, decreasing the money supply or strengthening
the international value of the currency.
This could be an attempt to cool off an economy and reduce inflationary pressures.
Now let’s consider an economy operating at full-employment.
The government wants to reign in economic activity so they increase interest rates,
decrease the money supply, strengthen the international value of the currency or some
combination of all.
This should eventually reduce AD from AD to AD1, causing a decrease in the price level
from PL* to PL1 and a fall in real GDP from Yfe to Y1.
This will come about as consumption, investment and the value of net exports falls.
Again, you should always evaluate monetary policy with respect to its magnitude and time
lag in being effective.
What degree of monetary policy is sufficient and how long will it take to be effective?
Consider other consequences also and perhaps other policy tools that may be more effective
in addressing economic problems.
That’s the in-depth introduction to monetary policy and its tools.
You should now have a firm understanding on how monetary policy can be used to impact
the economy.
If you have any questions or comments you can leave them below or email me at enhancetuition@gmail.com.
You can also visit me on www.enhancetuition.co.uk.
That’s us done for now and I will see you in the next one!