Monetary Policy - A2 Economics

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  • Created on: 15-06-13 10:07
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Monetary Policy
The government can influence the economy through the use of monetary policy. To do this,
they control interest rates, money supply and exchange rates.
How do interest rates affect AD?
1. Housing market
A fall in IR will decrease housing payments/mortgages. This therefore increases
demand for houses, which also increases price of houses. It also increases the
wealth effect (the price of their asset rises, which makes people feel wealthier). This
increases consumption, and thus aggregate demand. However, the exception is the
liquidity trap.
Liquidity trap
Keynes believed that higher government borrowing may not lead to higher IR, if the
economy is in a deep depression. When there is a liquidity trap, borrowing can
increase without IR increasing. This occurs as lenders are prepared to increase the
supply of money without a rise in IR. Monetary policy alone cannot be used to get the
economy out of the depression as IR is very low and consumers are not willing to
borrow due to poor expectations they have about the future. A decrease in IR does not
cause an increase in consumption or investment.
2. Wealth effect
If IR increased, the demand for houses would fall, which would subsequently
decrease the wealth effect. If there is a low interest rate, there will be increased
demand for bonds.
3. Investment
An increase in interest rates will lead to a fall in investment as the cost of borrowing
increases. There may be an opportunity cost.
4. Saving
An increase in interest rates will increase savings, thus creating a withdrawal.
5. Exchange rate
A decrease in the exchange rate will increase demand for domestic economy
(SPICED). Thus exports increase while imports fall.
6. Consumer durables
An increase in interest rates will decrease the demand for consumer durables. This
may impact employment, especially with regards to the accelerator.
What is the accelerator (theory)?
The accelerator theory states that whereas consumption is determined by national income,
investment is determined by changes in the national income. It will affect a firm's investment
decisions as firms see an increase in consumption, they may invest, in the short term, in
new machines and capital equipment. In the shortterm, this would lead to a monetary
increase in the physical capital ­ supporting the increase in consumption.

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Unit of account: In the unit of account, money serves as the common base of
comparison that people use to present prices and record debts. E.g. if a normal TV
cost £100 and a HD TV cost £200, we know what this means and so are able to
compare prices.
Demand for money
Individuals and firms tend to hold a variety of financial assets, which can be divided into
financial assets and physical assets.…read more

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The demand for money increases, for example, following an increase in income, more
money will be demanded at any given interest rate and the interest rate will increase from IR1
to IR2.…read more

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A fall in the demand for money will lead to a fall in the rate of interest. If the government
increases the money supply, the MS curve will shift to the right from MS1 to MS2. This will
lead to a fall in the IR from IR1 to IR2. A reduction in the money supply will lead to an increase
in the interest rate.…read more

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The bank's IR decisions affect interest rates set by mortgage lenders, commercial banks,
and financial institutions. These same decisions and announcements influence the
confidence and expectations or firms and households as well as asset prices and the
exchange rate.
AD is therefore affected ­ the domestic component of demand will be stimulated by lower
market IR as well as spending and investment by individuals and firms is boosted.
Conversely, higher market interest rates would tend to reduce domestic demand.…read more

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We receive £5.
If a firm can borrow cheaply, it is more likely to invest in machinery/equipment, or to buy
shares in other firms.
Quantitative Easing
Quantitative easing is a process whereby a Central Bank, such as the Bank of England,
purchases existing government bonds (gilts) in order to pump money directly into the
financial system. Quantitative easing (QE) is regarded as a last resort to stimulate spending
in an economy when interest rates fail to work.…read more

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The positive effects of this may then spread out to the real
The hope is that:
Bank lending starts to flow again, leading to increased household and corporate
Confidence rises as lending and spending increase.
Aggregate demand increases and the economy moves out of recession.
The inflation target (2%) is achieved rather than fall below target as might happen in
a recession or periods of low growth and poor expectations.…read more



This is a detailed 8 page summary of monetary policy including diagrams and quantitative easing. Students could use this to help their understanding or produce their own learning resources.

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