Monetary Policy

• Monetary policy involves changes to interest rates, the money supply, and the exchange rate by the central bank of an economy to influence aggregate demand
• Monetary policy is similar to fiscal policy as a demand-side policy aimed to influence aggregate demand
• Monetary policy is enacted by a country's central bank independent of the government
• The primary role of the Bank of England is to hit a 2% inflation target
• Types of monetary policy

  • Expansionary monetary policy
  • Contractionary monetary policy
• Expansionary monetary policy aims to boost aggregate demand
• Contractionary monetary policy aims to reduce aggregate demand
• Central banks use expansionary monetary policy to boost economic growth, reduce unemployment, and achieve macroeconomic stability
• Central banks use contractionary monetary policy to control inflation, prevent excessive growth of house prices, prevent excessive credit in the economy, balance economic growth, reduce excess debt, promote saving, and reduce the current account deficit
• Interest rates are a key component of expansionary monetary policy
• Interest rate cuts are a common tool in expansionary monetary policy to boost the economy
• An interest rate cut by the central bank affects a variety of interest rates in the economy through a transmission mechanism
• A cut in the central bank interest rate will affect a wide variety of interest rates in the economy
• Monetary policy transmission mechanism

  Central bank rate cut fears through different channels and hits the real economy
• Expansionary policy


  Central bank cuts interest rates to lead to lower credit card interest rates and lower borrowing costs for consumers
• Lower borrowing costs for consumers


  Makes it cheaper for consumers to borrow, incentivizes more borrowing, incentivizes less saving, increases the marginal propensity to consume
• Consumers borrow more


  They spend more on big-ticket items like cars, furniture, jewelry, etc., leading to an increase in aggregate demand
• Interest rates on savings accounts fall

  Reduces the incentive to save, increases the incentive to spend, boosts consumption
• Mortgage rates come down

  Households pay less monthly towards their mortgage payments, have more disposable income, increase their marginal propensity to consume, boost consumption
• Lower interest rates on business loans


  Increases the incentive for businesses to borrow, use money for investment purposes, boost growth
• Lower interest rates in the economy

  Can weaken the exchange rate, lead to hot money outflows, depreciate the currency, boost net exports
• Lower interest rates feed through into higher variables in the ad equation

  Leads to an increase in growth, reduction in unemployment, increase in demand-pull inflation
• Expansionary monetary policy and long-run aggregate supply


  Boosts long-term growth rates via an increase in investment, improvement in productive efficiency of the economy
• Monetary policy is a demand-side policy
• Link between expansionary monetary policy and long-run aggregate supply is a nice side effect, not the core intention
• Investment can boost long-term growth rates via an increase in the quantity and quality of capital, and improvement in productive efficiency of the economy