Monetary policy

Economics · Government and the macroeconomy. 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

The money supply is the total amount of money in an economy: notes and coins plus bank deposits. Monetary policy means changes in the rate of interest, the money supply or the foreign exchange rate made to influence total demand. It is usually carried out by the central bank.

The main tool is the interest rate. A higher rate makes borrowing dearer and saving more rewarding, so households spend less and firms invest less. Total demand falls and inflation slows, but growth and employment may suffer. A lower rate does the opposite.

A lower exchange rate makes exports cheaper and imports dearer, which raises total demand.

Rules to remember

Expansionary monetary policy: lower interest rate, larger money supply or lower exchange rate, so total demand rises
Contractionary monetary policy: higher interest rate, smaller money supply or higher exchange rate, so total demand falls
Higher interest rate → less borrowing and more saving → less consumer spending and investment → lower inflation
A higher interest rate also attracts savings from abroad, which raises demand for the currency and so its exchange rate
If the money supply grows much faster than output, the result is inflation
Limit: in a deep recession, low confidence can stop households and firms borrowing even when interest rates are cut
Fiscal policy uses taxes and government spending; monetary policy uses the interest rate, the money supply and the exchange rate

Common mistake

Calling a tax change a monetary policy measure. Taxes and government spending belong to fiscal policy; interest rates and the money supply belong to monetary policy.

Worked example

A central bank changes its rules so that commercial banks must keep a smaller share of their deposits in reserve. What kind of monetary policy is this, and which macroeconomic aims does it help and put at risk?

Banks can now lend out more of their deposits, and new loans create new bank deposits, so the money supply rises.
More lending means more spending by households and more investment by firms, so total demand rises.
Higher total demand raises output and employment, but it can also pull prices up.

Answer: It is expansionary monetary policy. It helps economic growth and employment but risks higher inflation.

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