3.5
Demand Management — Monetary Policy
Central bank tools, interest rates, money creation, and expansionary and contractionary monetary policy.
You should be able to
- Define monetary policy and identify the central bank's role
- State the goals of monetary policy
- Explain money creation by commercial banks HL
- Describe HL tools of monetary policy HL
- Distinguish real and nominal interest rates and calculate real rates
- Explain expansionary and contractionary monetary policy using AD/AS diagrams
- Evaluate the effectiveness of monetary policy
Note
This section is pending teacher review.
What is Monetary Policy?
Monetary policy is the use of control over the money supply and interest rates by the central bank to achieve macroeconomic objectives.
Goals of monetary policy
- Low and stable rate of inflation (most central banks use inflation targeting)
- Low unemployment
- Reduce business cycle fluctuations
- Promote stable economic environment for long-term growth
- External balance (exchange rate stability)
Nominal vs Real Interest Rates
Real interest rate (Fisher equation)
Real interest rate ≈ Nominal interest rate − Inflation rate
Example: If the nominal rate is 5% and inflation is 3%, the real rate is approximately 2%. The real rate is what matters for borrowing and saving decisions — it reflects the actual cost of borrowing in terms of purchasing power.
Expansionary and Contractionary Monetary Policy
| Expansionary (loose) | Contractionary (tight) | |
|---|---|---|
| Action | Central bank cuts interest rates / increases money supply | Central bank raises interest rates / reduces money supply |
| Effect on C and I | Lower borrowing costs → C and I rise → AD shifts right | Higher borrowing costs → C and I fall → AD shifts left |
| Used to close | Deflationary/recessionary gap (boost output and employment) | Inflationary gap (reduce inflationary pressure) |
Tools of Monetary Policy HL
| Tool | How it works |
|---|---|
| Open market operations (OMO) | Central bank buys or sells government bonds in the open market. Buying bonds injects money → lower interest rates (expansionary). Selling bonds withdraws money → higher rates (contractionary). |
| Minimum reserve requirements | Central bank sets the minimum fraction of deposits banks must keep as reserves. Lowering reserves → banks can lend more → money supply expands. Rarely used as a tool in most countries. |
| Changes in central bank lending rate | The base rate / discount rate at which the central bank lends to commercial banks. Lower rate → cheaper for banks to borrow → pass on lower rates to customers → expansionary. |
| Quantitative easing (QE) | Central bank creates new money to buy long-term assets (e.g., government and corporate bonds) when interest rates are already near zero. Aims to lower long-term rates and encourage lending. |
HL only — Money creation by commercial banks
Commercial banks create money through the process of credit creation (fractional reserve banking). When a bank receives a deposit, it keeps a fraction as reserves (e.g., 10%) and lends the rest. The borrower deposits the loan in another bank, which lends out 90% of that, and so on — each deposit creates new deposits. The money multiplier = 1 ÷ reserve ratio.
Effectiveness of Monetary Policy
Strengths
- Incremental and flexible — rates can be adjusted in small steps
- Relatively short time lags compared with fiscal policy
- Can be reversed quickly if conditions change
- Implemented by independent central banks, reducing political interference
Constraints
- Zero lower bound: nominal interest rates cannot fall below zero (in normal conditions) — limited room to cut rates when they are already near zero
- Low confidence: businesses and consumers may not borrow even at low rates if confidence is very low ("pushing on a string")
- Time lags between policy change and effect on spending and prices
- QE has uncertain effects and may increase asset price inequality
Key points to remember
- Monetary policy: central bank controls money supply and interest rates
- Real rate ≈ nominal rate − inflation rate
- Expansionary: cut rates → AD↑; Contractionary: raise rates → AD↓
- HL tools: OMO, reserve requirements, base rate, QE
- Strengths: flexible, short lags, reversible
- Weaknesses: zero lower bound, low confidence, uncertain QE effects
Note
Worked examples are pending teacher review.
Worked Example — Real Interest Rate
The nominal interest rate is 6%. The inflation rate is 2.5%.
Real interest rate ≈ 6% − 2.5% = 3.5%
A borrower pays 6% nominally, but the real cost in purchasing power terms is only 3.5% — inflation erodes the real burden of the debt.
A borrower pays 6% nominally, but the real cost in purchasing power terms is only 3.5% — inflation erodes the real burden of the debt.
Worked Example — Expansionary Monetary Policy
An economy is in a recessionary gap with high unemployment. The central bank cuts interest rates from 4% to 1.5%.
Lower interest rates → lower cost of borrowing for households and firms
→ Consumption (C) and investment (I) increase
→ AD shifts right
→ Real GDP rises and unemployment falls
→ Some upward pressure on the price level
This closes the recessionary gap and moves the economy toward full employment output.
→ Consumption (C) and investment (I) increase
→ AD shifts right
→ Real GDP rises and unemployment falls
→ Some upward pressure on the price level
This closes the recessionary gap and moves the economy toward full employment output.
Note
Practice questions are pending teacher review.
Practice Questions
1. The nominal interest rate is 7% and the inflation rate is 4%. Calculate the real interest rate and explain its significance.
Show answer
Real interest rate ≈ 7% − 4% = 3%. The real interest rate measures the true cost of borrowing in terms of purchasing power. At 7% nominal, borrowers pay back more in dollar terms — but since prices are rising at 4%, each dollar is worth less. The actual real burden is only 3%. The real rate determines investment and savings decisions: a low or negative real rate encourages borrowing and discourages saving.
2. Using an AD/AS diagram, explain how contractionary monetary policy can reduce an inflationary gap.
Show answer
In an inflationary gap, real output exceeds potential output (Y > YF). The central bank raises interest rates. This increases the cost of borrowing, reducing consumption (C) and investment (I). AD shifts left (AD2 to AD1). Real output falls back toward potential output (YF), and the price level falls. Inflationary pressure is reduced. Unemployment may rise slightly toward its natural rate.
3. Explain why monetary policy may be ineffective in a severe recession.
Show answer
In a severe recession, interest rates may already be near zero — the zero lower bound limits the central bank's ability to cut further. Even if rates are cut to zero, if consumer and business confidence is very low, households will save rather than spend and firms will not invest (the "liquidity trap" — like pushing on a string). Quantitative easing may be attempted, but its effectiveness is uncertain and it may mainly raise asset prices rather than stimulate real spending. Fiscal policy (increased government spending) may be more effective in a deep recession because it directly injects demand.