Monetary Policy

Question 1

What is monetary policy?

Answer 1

Decisions by the central bank on interest rates, money supply and the exchange rate

Question 2

What are the 2 types of monetary policy?

Answer 2

Expansionary policy (low interest, higher money supply, devalue currency) - BOOSTS AD and increases inflation

Contractionary (high interest, lower money supply, higher exchange rate) - REDUCES AD and inflation

Question 3

3 effects of a low interest rate?

Answer 3

• Increased demand for loans - demand for housing (mortgages) increases - house prices increase
• Disposable income of those with mortgages increases - cost of borrowing decreases - mortgage repayments fall - more disposable income
• Exchange rate falls - less hot money flows - less demand for currency. — However exports become cheaper so current account and AD improve

Question 4

What impact does monetary policy have on AS?

Answer 4

• Low interest encourages more investment as cost of borrowing falls
• Investment can be used to increase quality & quantity of factors of production e.g. buying more productive capital
• Increases productive capacity of economy - AS shifts right

Question 5

Evaluation of monetary policy

Answer 5

Pros

• Affects C+I+G and (X-M). There are further gains if there is a positive multiplier
• Can increase both AD and AS

Cons

• Causes demand-pull inflation as AD shifts right
• Time lag - interest rates take around 18 months to change
• Depends on confidence - consumers and firms may not consume or invest more if confidence is low

Question 6

What does the effect of monetary policy depend on?

Answer 6

• initial level of economic activity. If economy is operating near full capacity, increase in AD may not increase GDP growth (diagram analysis)
• The level of consumer/business confidence
• The size of of change in interest rates