Monetary policy
- Money supply - the total amount of money available in an economy at a particular time.
- Monetary policy - changes in interest rates, the money supply or the foreign exchange rate designed to achieve macroeconomic aims.
- Foreign exchange rate - the price of one currency expressed in another currency.
- Currency appreciation - a rise in the value of a currency, so one unit buys more foreign currency.
- Currency depreciation - a fall in the value of a currency, so one unit buys less foreign currency.
Monetary policy is normally implemented by the central bank or monetary authority. The exact system differs between countries, so an exam answer should follow the policy change given in the question.
| Measure | If tightened | If loosened | Main transmission chain |
|---|---|---|---|
| Interest rate | Rate rises | Rate falls | A higher rate rewards saving and makes borrowing dearer -> household and firm spending tends to fall -> total demand and inflationary pressure fall. |
| Money supply | Growth is restricted | More money/ credit is made available | Less available credit tends to raise borrowing costs and reduce spending; easier credit tends to raise spending and investment. |
| Foreign exchange rate | Authorities support appreciation | Authorities allow or encourage depreciation | Appreciation lowers import prices but makes exports less price-competitive; depreciation has the reverse effects. |
How monetary policy may meet the aims
- Control inflation: higher interest rates and tighter credit can reduce borrowing, spending and total demand; appreciation can also lower import costs
- Promote growth and employment: lower rates and easier credit can raise consumption and investment, increasing sales, output and jobs
- Improve balance of payments stability: higher rates may reduce import demand; depreciation may increase export demand and reduce import demand if buyers respond sufficiently
- Support sustainability or redistribution: effects are indirect and uncertain; interest-rate changes may affect borrowers, savers and housing costs differently
Evaluation: Interest-rate changes do not work instantly. Effects are stronger when households and firms are willing to borrow and spend, and weaker when confidence is low or debt is already high.