Monetary policy works through the cost of borrowing
Definition
Monetary policy: the decisions a central bank takes to influence the cost of borrowing and the amount of money in the economy.
Bank Rate: the Bank of England's own interest rate, which commercial banks use as the benchmark for the rates they charge and pay.
- The single lever that matters most is Bank Rate, because every other rate in the economy is priced off it.
- Moving it changes two things at once: what a borrower pays and what a saver earns.
- Those two prices then change how much households and firms choose to spend, which is how a decision about money reaches output and jobs.
- Monetary policy is separate from fiscal policy, covered in 3.5.3, because a different institution decides it and it uses a different instrument.
Common Mistake
Do not write that the government sets interest rates, because in the UK the Monetary Policy Committee does and ministers do not sit on it.
The Monetary Policy Committee decides Bank Rate
- The decision is taken by the Monetary Policy Committee, which has nine members and meets eight times a year (Source: Bank of England).
- The Bank is operationally independent, so it chooses the rate itself, but the government sets the target it has to hit.
- That target is 2% CPI inflation, and if inflation is more than one percentage point above or below it the Governor must write an open letter to the Chancellor explaining why (Source: Bank of England).
- Price stability is therefore the objective monetary policy is pointed at first, as set out in 3.4.1.
Example
- Bank Rate is 3.75%, cut there from 4.00% in December 2025 (Source: Bank of England).
- It has been held at every meeting since, and at the decision published on 30 July 2026 the vote was six to three, with the three in the minority wanting a rise rather than a cut.
- That split is worth noticing, because it shows a committee weighing inflation still above target against the risk of slowing the economy too far.
Note
- How the bank rate is decided is not part of the OCR GCSE economics syllabus.
A rate change reaches households and firms
Definition
Transmission mechanism: the path a Bank Rate decision follows before it changes spending, output and prices.
- Banks reprice first, so mortgages, loans, overdrafts and savings accounts move within weeks of the decision.
- Households then adjust: dearer credit means fewer purchases bought on borrowing, and a better savings rate means more income held back.
- Firms adjust next, because a higher cost of borrowing rules out investment projects whose expected return no longer covers it.
- Total spending in the economy moves only after all of that has happened, which is why the full effect takes many months.
How different interest rates change the amount people save, borrow and invest is covered in 2.8.4, and the calculations in 2.8.5.
Monetary policy is aimed at the objectives
- Price stability: raising Bank Rate cools spending, which takes pressure off prices when demand is running ahead of what the economy can supply.
- Growth and employment: cutting Bank Rate makes borrowing cheaper, so spending and investment rise and firms take on more workers, as in 3.1.5 and 3.2.1.
- One instrument cannot serve every objective at once, so the Committee has to decide which one matters most at the time.
Exam technique
- Name the instrument rather than writing that the Bank helped the economy, because the mark is in saying which rate moved and in which direction.
- Build the chain in order, from Bank Rate to the rates people face to their spending to prices and jobs, since a missing link is where answers lose their explanation.
Self review
- Define monetary policy in one sentence.
- Who decides Bank Rate in the UK, and how often do they meet?
- What inflation target is the Bank of England given, and who sets it?
- Describe the path a rise in Bank Rate takes before it reaches a household's spending.
- Why can monetary policy not achieve every economic objective at the same time?
