Cambridge Syllabus Notes

Effectiveness of Monetary Policy in Achieving Macro‑economic Objectives

1. Macro‑economic Objectives (Cambridge Syllabus 5.1, 10.1)

Monetary policy is a principal tool for helping an economy achieve the following objectives:

Price stability – keep inflation low and stable.
Low unemployment (full employment) – support a sustainable level of job creation.
Sustainable economic growth – promote a steady increase in real output without creating inflationary pressures.
Balance‑of‑payments stability – influence the exchange rate and capital flows to avoid large deficits or surpluses.
Development & sustainability (A‑Level) – ensure growth is environmentally sustainable, socially inclusive and reduces external debt vulnerability.

While “financial stability” is a desirable side‑effect, it is not a primary syllabus objective and is therefore presented only as a secondary benefit.

2. Monetary‑policy Tools (Cambridge Syllabus 5.3, 5.4)

Central banks have two groups of tools – conventional and unconventional. Each tool can be linked to the objectives above (see the evaluation matrix in §5).

2.1 Conventional tools

Tool	How it works	Primary objective(s) affected
Open Market Operations (OMO)	Buying (selling) government securities adds (removes) reserves, lowering (raising) market interest rates.	Price stability, growth, balance‑of‑payments (through exchange‑rate effects).
Discount (policy) rate	Rate at which commercial banks can borrow from the central bank; a change influences the whole interest‑rate structure.	Price stability, growth, unemployment.
Reserve requirements	Proportion of deposits banks must hold as reserves; altering this changes the amount of money banks can lend.	Growth, unemployment, balance‑of‑payments (via credit availability).

2.2 Unconventional tools (used when policy rates are near zero)

Tool	How it works	Primary objective(s) affected
Quantitative easing (QE)	Large‑scale purchases of long‑term government or corporate securities to lower long‑term yields and increase the money supply.	Growth, unemployment, price stability (via expectations), balance‑of‑payments (through capital‑flow effects).
Negative policy rates	Policy rate set below zero to penalise banks for holding excess reserves, encouraging lending.	Growth, unemployment.
Forward guidance	Publicly communicating the anticipated future path of policy rates to shape expectations of households, firms and investors.	Price stability (anchoring inflation expectations), growth, unemployment.

3. Transmission Mechanism

The impact of a policy decision moves through several channels before reaching the real economy. The mechanism can be understood through two core theories of money demand:

3.1 Liquidity‑preference theory

People hold money for transactions, precautionary and speculative motives.
A lower policy rate reduces the opportunity cost of holding money, increasing the quantity of money demanded (shifts the LM curve right).

3.2 Loanable‑funds theory

Supply of loanable funds comes from household saving and bank reserves; demand comes from firms’ investment and government borrowing.
Changes in the policy rate shift the supply curve of loanable funds (via reserves) and the demand curve (via investment sensitivity).

3.3 Main transmission channels

Interest‑rate channel – policy‑rate changes affect market rates, altering borrowing costs for households and firms.
Credit (bank‑lending) channel – reserves and banks’ willingness to lend change, influencing the volume of credit available.
Exchange‑rate channel – a lower domestic rate tends to depreciate the currency, making exports cheaper and imports more expensive.
Expectations channel – forward guidance and central‑bank credibility shape expectations of future inflation and output.

A simplified functional representation (used in the syllabus):

$$ \Delta i = f(\Delta M,\; \Delta \pi,\; \Delta Y) $$ where $i$ = nominal interest rate, $M$ = money supply, $\pi$ = inflation, $Y$ = real output.

4. Impact on Aggregate Demand and Aggregate Supply

4.1 Expansionary monetary policy

Lower policy rate → lower market rates → higher consumption (C) and investment (I).
Credit expansion → greater loanable funds → further boost to I.
Currency depreciation → increase in net exports (NX).
Result: AD shifts right (AD₁ → AD₂), raising real GDP. If the economy is near full capacity, upward pressure on the price level follows.

4.2 Contractionary monetary policy

Higher policy rate → higher market rates → lower C and I.
Reduced credit availability → less borrowing.
Currency appreciation → lower NX.
Result: AD shifts left (AD₂ → AD₁), reducing output and easing inflationary pressures.

4.3 Short‑run SRAS effects

Credible forward guidance that lowers expected future inflation can shift SRAS rightward (cost‑push pressures fall).
Conversely, expectations of higher inflation shift SRAS leftward, amplifying price rises.
In the long run, SRAS is vertical at potential output; monetary policy mainly influences AD, not SRAS.

4.4 Quantitative example (side box)

Example: Suppose the central bank cuts the policy rate by 1 %.
• The money multiplier is 4, so the money supply rises by 4 %.
• Using the simple AD equation $Y = C(Y‑T) + I(i) + G + NX(e)$, a 1 % fall in the real interest rate raises investment by 0.5 % and consumption by 0.3 %.
• Net exports rise by 0.2 % because the exchange rate depreciates by 2 %.
• Total change in AD ≈ +1 % → real GDP rises by about 0.8 % (assuming a Keynesian multiplier of 2).
This illustrates how a modest rate cut can generate a measurable shift in AD.

5. Evaluation of Monetary‑policy Tools (AO3)

Each tool is more or less effective for a particular objective. The matrix below summarises strengths and weaknesses.

Tool	Objective(s)	Strengths	Weaknesses / Limitations
Open Market Operations	Price stability, growth, BOP	Fast implementation; precise control of reserves.	Effectiveness reduced in shallow financial markets; limited impact on expectations.
Discount (policy) rate	Price stability, unemployment, growth	Direct influence on bank‑lending rates; visible to market.	Transmission lag; may be offset by capital‑flow reactions.
Reserve requirements	Growth, unemployment, BOP	Powerful lever on credit creation.	Coarse tool; large changes can destabilise banking sector.
Quantitative easing	Growth, unemployment, price stability (via expectations)	Works when policy rate is at the zero lower bound; lowers long‑term yields.	Risk of asset‑price bubbles; diminishing marginal impact; unwinding can be costly.
Negative policy rates	Growth, unemployment	Provides additional stimulus after rate cuts.	Bank profitability may suffer; banks may pass on rates to deposits rather than borrowers.
Forward guidance	Price stability, growth, unemployment	Shapes expectations without immediate market operations.	Relies on central‑bank credibility; unexpected shocks can render guidance ineffective.

6. Constraints and Limitations (AO2)

Time lags – recognition, implementation and effect lags mean impacts are felt months (or years) after a decision.
Liquidity trap – when nominal rates are at or near zero, further easing may not stimulate borrowing; the interest‑rate channel is muted.
Expectations and credibility – if agents doubt the central bank’s commitment, policy may be ineffective or even destabilising.
International capital flows – in open economies, large inflows/outflows can offset domestic policy (e.g., a rate cut may be neutralised by capital flight).
Balance‑of‑payments considerations – aggressive easing can cause a sharp depreciation, increasing the cost of external debt servicing.
Structural rigidities – labour‑market inflexibility, supply‑side bottlenecks, and weak financial intermediation limit the ability of demand‑side policy to raise output.
Policy conflicts (A‑Level) – simultaneous goals of low inflation and high growth can be mutually exclusive; monetary policy may need to prioritise one objective over another.
Government‑failure in monetary policy – political pressure, lack of independence, or short‑termism can undermine credibility and effectiveness.

7. Trade‑offs, Policy Mix and the Phillips Curve (AO2)

The short‑run Phillips curve illustrates the trade‑off between inflation and unemployment:

$$ \pi = \pi^{e} - \beta (u - u^{n}),\qquad \beta>0 $$

$\pi$ = actual inflation, $\pi^{e}$ = expected inflation, $u$ = unemployment, $u^{n}$ = natural rate.
Expansionary monetary policy shifts AD right, reducing unemployment but raising inflation (movement up the Phillips curve).
Contractionary policy does the opposite.

Because monetary policy influences both $\pi$ and $u$, policymakers must balance:

Reducing inflation (tightening) versus supporting employment (easing).
Short‑run output gains against the risk of higher future inflation expectations.

Co‑ordination with fiscal policy can improve outcomes. For example, an expansionary fiscal stance can complement a modest monetary easing to boost growth without igniting inflation, whereas a simultaneous fiscal tightening may neutralise monetary stimulus.

8. Monetary Policy and Exchange‑rate Regimes (Cambridge Syllabus 11.1‑11.5)

Floating regime – monetary policy determines the exchange rate; the exchange‑rate channel is fully operative.
Managed (dirty‑float) regime – central bank may intervene to smooth excessive volatility; policy still influences the rate but with occasional sterilised intervention.
Fixed or pegged regime – the central bank must defend the parity; monetary policy loses autonomy because interest‑rate changes trigger capital flows that threaten the peg.

Consequently, the ability of monetary policy to achieve balance‑of‑payments stability depends on the exchange‑rate regime:

Regime	Policy autonomy	Typical BOP tool
Floating	High – rates set by domestic conditions.	Interest‑rate adjustments; exchange‑rate moves automatically.
Managed	Moderate – occasional intervention.	Sterilised foreign‑exchange intervention plus rate changes.
Fixed/peg	Low – must align rates with foreign anchor.	Foreign‑exchange reserves; capital controls; limited rate changes.

9. Development, Sustainability and Monetary Policy (A‑Level)

Monetary policy can affect investment in green technologies through lower long‑term rates (QE) and targeted credit facilities.
Excessive credit growth may increase household debt vulnerability, especially in developing economies with limited financial regulation.
Exchange‑rate depreciation can improve the terms of trade for commodity‑exporting countries, aiding development, but may also raise import‑price inflation.
Policy coordination with structural reforms (labour market flexibility, education, infrastructure) is essential for sustainable long‑run growth.

10. Evaluation of Unconventional Tools (AO3)

Tool	Primary Aim	Potential Effectiveness	Key Limitations
Quantitative Easing (QE)	Lower long‑term rates & increase asset‑price wealth when policy rate ≈ 0.	Can revive credit growth and raise AD in a liquidity trap; useful for anchoring inflation expectations.	Risk of asset‑price bubbles, diminishing marginal impact, and inflationary pressure if unwound abruptly.
Negative Policy Rates	Encourage banks to lend rather than hold excess reserves.	May stimulate borrowing when conventional cuts are exhausted.	Potential erosion of bank profitability; banks may pass negative rates onto deposits rather than borrowers.
Forward Guidance	Shape expectations about the future path of policy rates.	Effective in anchoring inflation expectations and reducing uncertainty, thereby influencing consumption and investment.	Relies heavily on credibility; unexpected shocks can render guidance ineffective.

11. Case Study: The 2008 Global Financial Crisis

Policy response: rapid cuts to policy rates (many central banks to near‑zero) and large‑scale QE programmes.
Transmission: lower short‑ and long‑term rates restored confidence, prevented a collapse of credit, and shifted AD rightward.
Outcomes:
- Averted a deeper recession and a potential deflationary spiral.
- Raised debates about long‑run inflation risk, asset‑price inflation (housing, equities) and “moral hazard” for financial institutions.
- Highlighted the importance of central‑bank credibility and the limits of conventional tools in a liquidity trap.

12. Summary Table – Impact of Main Monetary‑policy Tools (AO1‑AO2)

Tool	Primary Effect on Money Supply / Rates	Impact on Inflation (ceteris paribus)	Impact on Output / Employment (ceteris paribus)
Open Market Operations	Buy securities → increase reserves → lower market rates; Sell → opposite.	↓ with contraction; ↑ with expansion.	↓ with contraction; ↑ with expansion.
Discount (Policy) Rate	Changes the cost of borrowing for banks.	↓ if cut; ↑ if raised.	↑ if cut; ↓ if raised.
Reserve Requirements	Higher ratio → less loanable funds; lower ratio → more.	↓ when ratio lowered; ↑ when raised.	↑ when lowered; ↓ when raised.
Forward Guidance	Signals future rate path → shapes expectations.	Can anchor inflation expectations, limiting inflation.	Can boost confidence and investment, raising output.
Quantitative Easing (Unconventional)	Purchases long‑term securities → lower long‑term yields, increase asset prices.	Potentially ↓ inflation in the long run if it restores price stability; short‑run effect modest.	↑ output in the short run via wealth and credit effects.
Negative Policy Rates	Policy rate set below zero; penalises excess reserves.	↓ if banks pass on lower rates; ambiguous otherwise.	↑ if lending rises; limited if banks retain deposits.

13. Suggested Diagram

Figure: Monetary‑policy transmission mechanism – flow from the central bank’s policy decision → interest‑rate, credit, exchange‑rate and expectations channels → shifts in AD (and, where expectations affect costs, SRAS) → impact on inflation, output and the balance of payments.

monetary policy