Interest rates

• Nominal interest rate


  The actual rate agreed upon between a bank and a customer; the rate borrowers have to pay or the return the saver receives
• Real interest rate


  Accounts for the impact of inflation on interest rates
• Expansionary monetary policy (or loose/easy monetary policy)


  A policy that boosts economic activity by expanding money supply. This is achieved mainly by lowering interest rates, stimulating aggregate demand and closing deflationary gaps
• Contractionary monetary policy (or tight monetary policy)


  A policy that reduces economic activity by restricting the money supply. This is achieved mainly by increasing interest rates, suppressing aggregate demand and closing inflationary gaps
• Consumption and investment aren't entirely dependent on interest rates as consumer and business confidence also plays a role
• Real interest rate = Nominal interest rate - Inflation rate
• A consequence of loose monetary policy is the potential emergence of inflationary pressures. When AD shifts right, the PL may go up, especially if the economy is operating at full capacity.
• On its own, expansionary monetary policy does not necessarily solve macroeconomic problems such as high unemployment and low economic growth, especially as there is limited scope to reduce interest rates further when they are already close to zero.
• The ability to adjust interest rates can allow easy monitoring of the effectiveness of monetary policy without high risk of disrupting the economy (Incremental).
• The independence of central bank allows decision-makers, in theory, to have the flexibility to act in the best interest of the economy without political influence (flexibility).
• The government can easily reverse the policy if needed. Flexibility also allows changes in interest rates to be quickly implemented. Thus, monetary policy can be use to fine-tune macroeconomic objectives (Easily reversible).
• Strengths of Monetary Policy

  1. Incremental
  2. Flexibility
  3. Easily reversible
• Monetary policy may be preferred to fiscal policy because it can be implemented more quickly. However, there are time lags to the reaction of households and firms to changes in interest rates, especially if confidence levels are low.