Monetary Policy – AS/A LEVELS/IB/IAL

Monetary Policy – AS/A LEVELS/IB/IAL

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Monetary Policy

Monetary Policy is the manipulation of interest rates and money supply.

Monetary Policy is set by the Bank of England’s Monetary Policy Committee (MPC). The committee has nine members who meet on a monthly basis to discuss whether interest rates should be increased or decreased. The MPC are also responsible for trying to achieve the UK’s inflation target of 1-3%.

Monetary Policy is a demand side policy that impacts aggregate demand (AD).

Key Terms – Monetary Policy

Expansionary/ Inflationary/Loose – Monetary Policy

This occurs when the MPC decides to reduce interest rates to stimulate growth. This causes a shift to the right of the AD curve.

Contractionary/ Deflationary/Tight – Monetary Policy

This occurs when the MPC decides to increase interest rates to slow down growth. This causes a shift to the left of the AD curve.

Monetary Policy – Impacts of changes in Interest rates

Reduction in interest rates

  • A decrease in interest rates will help to stimulate growth in the UK economy.
  • A decrease in rates will encourage consumers to borrow rather than save.
  • Low rates will encourage borrowing as consumers and businesses will have to pay back less interest on money borrowed.
  • This will increase consumption (C) and investment (I) and shift the AD curve to the right.

Increase in interest rates

  • An increase in interest rates will slow down growth in the UK economy.
  • A decrease in interest rates will encourage consumers to save rather than borrow.
  • High rates will encourage saving as consumers and businesses will earn high levels of interest on savings.
  • High rates will discourage borrowing as more interest would have to be paid back on money borrowed.
  • Therefore higher interest rates would decrease consumption (C) and investment (I) and shift the AD curve to the left.

Impact of interest rates on mortgage payments

  • A mortgage payment is a loan taken out normally from a bank or building society to purchase property or land.
  • It’s important to keep in mind that a property is the largest asset owned by most people.
  • Mortgage payments are also normally the largest outgoing monthly costs for a large number of the UK population.
  • Therefore interest rates have major impacts on consumer’s mortgage repayments. Mortgages will impact the amount of disposable income consumers will have after paying their mortgage liabilities.
  • Consumers have a choice to go for a fixed or variable mortgage rate. Consumers on fixed mortgages will not be impacted by changes in interest rates for the term of their mortgage. However those on variable rate mortgages could either benefit from interest rate drops or suffer from interest rate increases.

Problems with Monetary Policy

  • Time Lags – It takes a long time for the impact of monetary policy to be felt on the economy.
  • Impacts whole economy – A change in interest rates will impact the whole economy and can’t be used to only simulate a particular sector of the economy.
  • Liquidity Trap – This occurs when low interest rates fail to stimulate aggregate demand due to low consumer and business confidence. Banks will also restrict funds as they feel lending is risky during this period of time.
  • Impacts on exchange rates – Contractionary monetary policy will increase the exchange rate and make UK exports less competitive.
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