Defining monetary policy
Definition
Monetary policy: the use by a central bank of interest rates, the money supply and credit regulations to influence aggregate demand and meet macroeconomic objectives such as price stability.
Central bank independence: an arrangement in which the government sets the objective, such as an inflation target, while the central bank freely chooses the instruments used to hit it.
Who conducts it
- In most economies an independent central bank conducts monetary policy day to day.
- The government usually sets the objective, such as a 2% inflation target, and leaves the choice of instruments to the bank.
- This separation shields rate decisions from short-term political pressure, which strengthens the credibility of the target.
Key Idea
- Monetary policy is a demand-side policy run by the central bank.
- It works by changing the cost and availability of borrowing, so it moves AD rather than AS.
The three instruments
- The policy interest rate is the main instrument of monetary policy.
- It anchors the cost of borrowing across the whole economy, from mortgages to business loans.
- The money supply is the total stock of money circulating in the economy.
- Tools such as quantitative easing raise the quantity of money and push down longer-term interest rates.
- Credit regulations control how freely banks can lend.
- Tighter rules make loans harder to obtain, even when the interest rate is unchanged.
Effect on aggregate demand
- A lower policy rate makes borrowing cheaper, so consumption and investment rise.
- Higher spending lifts aggregate demand and real output, and near full capacity the price level.
- A higher policy rate does the reverse, cooling demand to curb inflation.
Example
- Suppose the Bank of England cuts its policy rate from 4% to 3% to support a weak economy.
- Banks pass this on, so a tracker mortgage on £200,000 costs roughly £2,000 a year less in interest.
- With more spare income and cheaper loans, households spend more and firms bring forward investment.
- Consumption and investment both rise, so aggregate demand increases.
- On an AD/AS diagram (average price level on the vertical axis, real output on the horizontal), AD shifts right from AD1 to AD2.
- Equilibrium real output rises towards full employment, though the size of the gain depends on how confident borrowers feel.
Exam technique
- Define monetary policy as the central bank's use of interest rates, the money supply and credit regulations.
- Always state clearly that it is a demand-side policy.
- Trace the chain from the interest rate to borrowing, spending and aggregate demand.
Common Mistake
- Do not confuse monetary policy with fiscal policy.
- Fiscal policy uses taxation and government spending, not interest rates.
- Do not assume the government sets the policy rate; an independent central bank typically does.
Self review
- Define monetary policy in one sentence.
- Who conducts monetary policy in most economies?
- Name the three categories of monetary policy instrument.
- How does a cut in the policy rate affect aggregate demand?
- Is monetary policy a demand-side or supply-side policy?
