Monetary policy measures: changes in interest rate

Government and the Macro‑economy – Monetary Policy

Topic: Monetary policy measures – changes in interest rate

Learning Objectives

• Define monetary policy and the role of the central bank.
• Explain how changes in the policy interest rate are implemented.
• Describe the transmission mechanism from interest‑rate changes to the real economy.
• Analyse the likely effects on aggregate demand, inflation, exchange rates and unemployment.
• Evaluate the advantages and limitations of using interest‑rate policy.

1. What is Monetary Policy?

Monetary policy is the set of actions undertaken by a country’s central bank to influence the quantity of money and the cost of borrowing (the interest rate) in order to achieve macro‑economic objectives such as price stability, full employment and sustainable economic growth.

2. The Central Bank’s Main Interest‑Rate Tool

The most common instrument is the policy (or base) interest rate – often called the “repo rate”, “official bank rate” or “discount rate”. By raising or lowering this rate the central bank influences the rates that commercial banks charge their customers.

3. How a Change in the Policy Rate is Implemented

1. The central bank announces a change in the policy rate at its monetary‑policy meeting.
2. It conducts open‑market operations (buying or selling government securities) to adjust the amount of reserves in the banking system.
3. Commercial banks’ cost of obtaining reserves changes, leading them to adjust their own lending and deposit rates.

4. Transmission Mechanism

The chain of events that links a change in the policy rate to the real economy is shown below.

4.1 Effect on Borrowing and Saving

• Higher policy rate: commercial‑bank lending rates rise, making loans more expensive; households and firms reduce borrowing.
• Lower policy rate: lending rates fall, encouraging borrowing.
• Higher rates also increase the return on savings, encouraging households to save rather than spend.

4.2 Effect on Investment (I) and Consumption (C)

Investment demand is particularly interest‑rate sensitive because firms compare the cost of financing with expected returns. Consumption of durable goods (cars, appliances) also depends on credit costs.

4.3 Effect on Net Exports (NX)

Changes in the domestic interest rate affect the exchange rate (E). A higher rate tends to appreciate the domestic currency, making exports more expensive and imports cheaper, reducing net exports.

4.4 Aggregate Demand (AD) Impact

The overall effect on AD can be expressed as:

\$\Delta AD = \Delta C + \Delta I + \Delta G + \Delta NX\$

where \$\Delta C\$, \$\Delta I\$ and \$\Delta NX\$ are influenced by the interest‑rate change; \$\Delta G\$ (government spending) is unchanged by monetary policy.

5. Expected Macro‑economic Outcomes

6. Advantages of Using Interest‑Rate Policy

• Quick to implement once the decision is made.
• Transparent – market participants can see the policy rate.
• Flexible – can be adjusted frequently in response to economic data.
• Indirectly influences a wide range of economic variables (investment, consumption, exchange rate).

7. Limitations and Potential Problems

• Liquidity trap: when interest rates are already very low, further cuts may not stimulate borrowing.
• Time lags – the effect on output and inflation can take 6‑18 months to materialise.
• Interest‑rate changes can have distributional effects (e.g., savers vs borrowers).
• Exchange‑rate volatility may arise, affecting export‑oriented sectors.
• Coordination with fiscal policy is required for maximum effectiveness.

8. Sample Exam Question and Mark Scheme

Question: Explain how a rise in the central bank’s policy interest rate is likely to affect the level of aggregate demand in the short run. (8 marks)

Mark scheme (summary):

1. Identify that a higher policy rate leads to higher commercial‑bank lending rates. (1)
2. Explain that higher borrowing costs reduce consumer credit and firm investment. (2)
3. State that higher rates increase the return on savings, encouraging households to save rather than spend. (1)
4. Note the likely appreciation of the domestic currency, reducing net exports. (1)
5. Combine the above to show that consumption, investment and net exports all fall, so AD falls. (2)
6. Conclude that, ceteris paribus, output and employment are likely to fall in the short run. (1)

9. Key Take‑aways

• Interest‑rate policy is the primary monetary‑policy tool used by most central banks.
• Changes affect the economy through the borrowing‑saving decision, investment, exchange rates and ultimately aggregate demand.
• The direction of the effect is predictable, but the magnitude depends on the sensitivity of consumption, investment and net exports to interest‑rate changes.
• Policy makers must consider time lags, the state of the economy and possible side‑effects when setting rates.