3.6 Monetary policy

Question 1

Define monetary policy

Answer 1

A policy that aims to control the total supply of money in the economy to try to achieve the government’s economic objectives, in particular price stability

Question 2

How can monetary policy be used to create economic growth?

Answer 2

• Interest rates: reduced
• Effect: Increased spending, output and employment

Question 3

How can monetary policy be used to create lower unemployment?

Answer 3

• Interest rates: reduced
• Effect: increased spending, output and employment

Question 4

How can monetary policy be used to create price stability?

Answer 4

• Interest rates: increased
• Effect: reduced spending, therefore more price stability

Question 5

How can monetary policy be used to create a healthier balance of payments?

Answer 5

• Interest rates: increased
• Effect: reduced spending (including spending on imports)

Question 6

How does monetary policy affect growth (assuming that the rate of interest decreases)?

Answer 6

Assuming that the rate of interest decreases:
- Spending and borrowing by consumers increases (borrowing is cheaper so disposable incomes rise)
- Borrowing for investment by firms increases (borrowing is cheaper so firms can increase investment, leading to more output)
- UK exchange rate decrease (lower interest rates lead to a fall in demand for pounds. Exports are now cheaper and imports dearer, therefore greater demand for UK goods and services, leading to more output)

Question 7

How does monetary policy affect employment (assuming that the rate of interest decreasess)?

Answer 7

Assuming that the rate of interest decreases:
- Spending and borrowing by consumers increases (leads to more demand for UK goods and services so more people are employed to provide these)
- Borrowing for investment by firms increases (leads to more spending on goods so suppliers employ more people. More investment may lead to the growth of firms and therefore greater employment)
- UK exchange rate decrease (more demand for UK goods and services and less demand for imports, therefore greater employment to meet the rising demand)

Question 8

How does monetary policy affect price stability (assuming that the rate of interest increase)?

Answer 8

Assuming that the rate of interest increases:
- Spending and borrowing by consumers decreases
- Borrowing for investment by firms decreases
- UK exchange rate increase

Question 9

What is the effect of decreased interest rates on consumer spending?

Answer 9

• Opportunity cost of spending: consumers spend more and save less
• Increase in spending
• Income: retired people who rely on income from savings may now spend less as their incomes fall
• Mortgage owners: those with mortgages now pay less interest so have more disposable income and can spend more.

Question 10

What is the effect of decreased interest rates on consumer borrowing?

Answer 10

• Consumption: consumers can borrow more as interest payments are less
• Consumer confidence: if consumers lack confidence in the economy, a cut in interest rates may not lead to more borrowing
• Mortgages: more people can afford to buy houses/buy larger houses

Question 11

What is the effect of decreased interest rates on consumer saving?

Answer 11

• Consumption: should rise and savings decrease as the opportunity cost of consuming is less. Those who depend on income from saving may have to reduce consumption
• Fall in price level: if prices are falling, then a cut in interest rates may not affect saving as people can consume more due to the price change
• Real rate of interest: if the real rate of interest still exceeds the rate of inflation, then people may save more as the value of savings is rising
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Question 12

What is the effect of decreased interest rates on investment?

Answer 12

• Increased loans (borrowing) interest payments are less
• Decreased saving (as less reward for saving) leading to retained profits