Monetary policy

Economics AS · Government macroeconomic intervention. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Monetary policy is the use of interest rates, the money supply and credit regulations to influence aggregate demand (AD). It is usually carried out by the central bank.

Expansionary monetary policy means lower interest rates, a larger money supply or easier rules on lending. Borrowing becomes cheaper and saving gives a smaller reward, so consumption and investment rise and AD shifts right. Contractionary policy is the opposite: higher interest rates, a smaller money supply or tighter credit rules, so AD shifts left.

The result depends on spare capacity. With spare capacity, higher AD mainly raises real output and employment. At full employment, higher AD only raises the price level.

Rules to remember

Monetary policy = use of interest rates, money supply and credit regulations to influence AD.
Tools: interest rates; money supply (for example the central bank buying or selling government bonds); credit regulations (limits on bank lending, minimum deposits for loans).
Expansionary: lower interest rates, more money, easier credit. AD shifts right.
Contractionary: higher interest rates, less money, tighter credit. AD shifts left.
Higher interest rates reduce consumption and investment, and also attract foreign savings so the currency rises and net exports fall.
AD shifts right on the upward-sloping part of AS: real output, employment and the price level all rise.
AD shifts right on the vertical part of AS: only the price level rises.

Common mistake

Changing taxes or government spending is fiscal policy, not monetary policy. Monetary policy is about interest rates, money and credit, and it shifts AD, not LRAS.

Worked example

An economy is on the upward-sloping section of its aggregate supply curve and inflation is above target. The central bank raises interest rates. What happens to real output, the price level and unemployment?

Higher interest rates make borrowing dearer and saving more attractive, so consumption and investment fall.
Aggregate demand falls, so the AD curve shifts to the left along the upward-sloping AS curve.
The new equilibrium has a lower real output and a lower price level.
Firms produce less, so they need fewer workers and unemployment rises.

Answer: Real output falls, the price level falls (inflation slows) and unemployment rises.

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