3.6 Monetary Policy

• Monetary policy is the main policy used to control inflation by the govt. . If inflation is too high, then the Bank of England will raise interest rates to bring inflation back within the target range of 1-3% inflation.
• Monetary Policy is defined as ''a policy that aims to control the total supply of money in the economy to try to achieve the government economic objectives, particularly price stability''
• The interest rate is defined as ''the reward for saving and the cost of borrowing''.
• The base rate can be altered to achieve any objective which the govt. has. This is because changes in the base rate will alter the level of AD.
• • To lower inflation... increase the base rate (lower demand-pull inflation).
• • To reduce unemployment... lower the base rate
• • To increase economic growth... lower the base rate
• 'Expansionary' monetary policy is where there is an increase in AD.

  'Reflationary' monetary policy is where there is a decrease in AD.

  (see diagrams in notes)
• Monetary policy can affect economic growth. An 'expansionary' policy is used, so the base rate and IR's are now lower -> Lower IR's leads to an increase in consumer spending due to disincentive to save, cheaper 'variable rate' mortgages or cheaper personal loans. In turn, there will be increased AD, and these higher levels of AD lead to increased output, so growth occurs.
• Monetary policy can affect economic growth. Following on from the last card, lower IR's also increase investment as it's cheaper for firms to borrow money for capital goods, therefore increasing AD. -> lower IR's also increase net exports (X-M), as lower IR's will lower the exchange rate, making exports cheaper/imports more expensive, causing a rise in AD. Overall, *see diagram in notes* an increase in AD (AD1 to AD2) leads to an increase in price level (P1 to P2), causing an increase in real GDP (GDP1 to GDP2), therefore initiating economic growth.
• Monetary policy can affect employment. Lower IR's -> Increased consumer spending (C) and also an increase in investment by firms (I) -> AD rises *see expansionary diagram* -> output rises -> to produce more, firms employ more workers (higher 'derived' demand for labour) -> Cyclical unemployment falls.
• Monetary policy can affect price stability. Increased IR's will raise the cost of borrowing and increase incentives to save, so lower (C), and they will also raise the cost of borrowing for investment, so lower (I). It will also put upwards pressure on the UK's exchange rate, leading to exports being more expensive, so lower (X-M). --> Overall, as a result of all of this, AD will fall. -> With lower AD there is now reduced pressure on process -> Lower demand-pull inflation.
• The positive impact of monetary policy on consumer spending is that a fall in interest rates should lead to a rise in consumer spending. This is because variable rate mortgages will be cheaper... so households have more disposable income left every month to spend. Saving is now less attractive... as less is saved, more money will be spent. Personal loans become cheaper, more money is therefore borrowed and also spent.
• A counter argument to the positive impact of monetary policy on consumer spending is that the full impact of a change in IR's is unknown. A cut in IR's should lead to a rise in consumer spending and lower savings, but if consumer confidence is low and people are uncertain about the future then they may decide to save, just in case. Therefore, there is no rise in consumer spending, so no rise in AD.
• In Judgement, the impact of monetary policy will depend upon how big the change in IR's is.
• The positive impact of monetary policy on borrowing is that lower IR's will encourage greater borrowing by firms. This is because loans are now cheaper to take out. Many households use loans and money in order to finance 'big ticket items' such as cars, furniture and holidays. If it becomes cheaper to borrow money then effectively it becomes cheaper to finance the purchase of these goods.
• A counter argument to the positive impact of monetary policy on borrowing is that consumer confidence is a vital determinant of borrowing. If people think they might lose their jobs in the future and lack confidence then they will spend less and also not be willing to borrow money.
• The impact of monetary policy on saving is that a fall in IR's will reduce the incentive to save money. This is because as IR's fall the opportunity cost of spending money (rather than saving it) also falls. E.g. if IR's fall from 4% to 2% then someone with £1000 in the bank now only earns £20 in interest. Therefore by spending (not saving) the £1000, then only £20 interest is forgone/ given up when spending the money.
• A counter argument to the impact of monetary policy on saving is that the full impact of a change in IR's is unknown. A cut in IR's should lead to a rise in consumer spending and lower savings, but if consumer confidence is low and people are uncertain about the future then they may decide to save, just in case. Therefore, there is no rise in consumer spending, so no rise in AD.
• The impact of monetary policy on investment by firms is that as IR's rise, firms will invest less into capital equipment. This is because there is an inverse relationship between the IR and the level of investment (see diagram in notes), so because IR's are now higher, then it is more expensive for firms to borrow money... so fewer firms wish to invest in new capital equipment. Additionally, the opportunity cost of firms not saving is now higher... because they would receive a higher IR on any money deposited in banks.
• A counter argument to the impact of monetary policy on investment is that if businesses lack confidence for the future, then no matter how strong the economy is now, they will be unlikely to undertake significant purchases of capital equipment today. They are more likely to wait and save money they have, and delay investment decisions.