Monetary Policy – Interest‑Rate Measures (IGCSE/A‑Level)
Learning Objectives
- Define monetary policy, money supply and the role of the central bank.
- State the three monetary‑policy tools used by most IGCSE economies: interest‑rate policy, money‑supply operations and foreign‑exchange intervention.
- Explain how a change in the policy interest rate is decided and put into practice.
- Describe the transmission mechanism from the policy rate to the real economy.
- Analyse the likely effects on the five macro‑economic aims (price stability, full employment, economic growth, balance‑of‑payments stability, redistribution) and on sustainability.
- Identify the three recognised time‑lags (recognition, implementation, impact).
- Evaluate the advantages and limitations of interest‑rate policy (AO3).
- Draw and interpret the required interest‑rate transmission diagram.
1. What is Monetary Policy?
Monetary policy is the set of actions taken by a country’s central bank to influence:
- The quantity of money (money supply) circulating in the economy.
- The cost of borrowing – i.e. the interest rate.
Its main macro‑economic objectives are the same five aims that appear in the Cambridge syllabus:
- Price stability (control of inflation)
- Full employment / low unemployment
- Economic growth (sustainable increase in output)
- Balance‑of‑payments stability
- Equitable distribution of income (redistribution)
- Environmental sustainability (where relevant)
2. The Three Monetary‑Policy Tools
| Tool | What it does | How the central bank implements it |
|---|
| Interest‑rate policy | Changes the cost of borrowing for commercial banks and, through them, for households and firms. | Adjustment of the policy (base) rate – often called the “official bank rate”, “repo rate” or “discount rate”. |
| Money‑supply operations (Open‑Market Operations – OMO) | Directly alters the amount of reserves in the banking system, shifting the money supply. | Buying government securities (injects reserves → expands money supply) or selling them (withdraws reserves → contracts money supply). |
| Foreign‑exchange intervention | Influences the exchange rate, which in turn affects the money supply and aggregate demand. | Central bank buys or sells foreign currency in the FX market; purchases increase domestic money supply, sales reduce it. |
3. How a Change in the Policy Rate is Decided and Implemented
- Decision: The Monetary Policy Committee (MPC) meets (usually quarterly) and decides whether to raise, lower or keep the policy rate unchanged, based on its assessment of inflation, output gaps, exchange‑rate pressures, etc.
- Announcement: The new rate is published in a press release and explained in a monetary‑policy statement.
- Implementation via OMOs:
- Raise the rate: Sell government securities → banks’ reserves fall → the cost of obtaining reserves rises → commercial‑bank lending rates move up.
- Lower the rate: Buy government securities → reserves rise → the cost of borrowing falls → commercial‑bank lending rates move down.
- Transmission to the market: Commercial banks adjust their own deposit and loan rates in line with the new cost of funds.
4. Transmission Mechanism (Flow‑Chart)
In the exam you should be able to draw the following diagram and label each arrow.
Policy rate → Commercial‑bank lending & deposit rates → Borrowing & saving decisions → Consumption (C), Investment (I) & Net exports (NX) → Aggregate Demand (AD)
- Arrows pointing up indicate a rise; arrows pointing down indicate a fall.
- Explain each link in a few sentences (see sections 5‑7).
5. Detailed Effects of a Policy‑Rate Change
5.1 Borrowing and Saving
- Higher policy rate: Commercial‑bank lending rates rise → loans become more expensive → households and firms cut back on borrowing.
Higher deposit rates increase the return on savings → households are more likely to save than spend. - Lower policy rate: The opposite – cheaper credit encourages borrowing; lower returns on deposits encourage spending.
5.2 Consumption (C) and Investment (I)
- Investment is highly interest‑rate sensitive: firms compare the cost of financing with expected marginal returns. A higher rate raises the hurdle rate, reducing I.
- Consumption of durables (cars, appliances, housing) also depends on credit costs; a higher rate reduces C, while a lower rate raises it.
5.3 Exchange Rate and Net Exports (NX)
- Higher domestic rates attract foreign capital → demand for the domestic currency rises → the currency appreciates.
- An appreciated currency makes exports relatively more expensive and imports cheaper → NX falls.
- Lower rates tend to cause depreciation, boosting NX.
5.4 Aggregate Demand (AD)
Because monetary policy does not directly affect government spending, ΔG = 0. The change in AD can be written as:
\$\Delta AD = \Delta C + \Delta I + \Delta G + \Delta NX\$
Typical direction of change:
- Rate rise → ΔC ↓, ΔI ↓, ΔNX ↓ → AD falls.
- Rate cut → ΔC ↑, ΔI ↑, ΔNX ↑ → AD rises.
5.5 Numerical Illustration (optional)
| Component | Assumed change (million $) |
|---|
| ΔC | ‑2 |
| ΔI | ‑3 |
| ΔG | 0 |
| ΔNX | ‑1 |
| ΔAD | ‑6 |
|---|
This simple example shows that a rise in the policy rate can reduce AD by $6 million.
6. Expected Macro‑Economic Outcomes
| Direction of Policy‑Rate Change | Aggregate Demand | Price Level / Inflation | Unemployment | Exchange Rate | Balance of Payments | Redistribution & Sustainability |
|---|
| Increase | ↓ C, ↓ I, ↓ NX → AD falls | ↓ inflationary pressure (price stability improves) | Short‑run ↑ unemployment | Domestic currency appreciates | Current account worsens (NX falls) → possible deficit | Savers gain (higher returns); borrowers lose; slower growth may affect long‑run sustainability. |
| Decrease | ↑ C, ↑ I, ↑ NX → AD rises | ↑ inflationary pressure (price stability deteriorates) | Short‑run ↓ unemployment | Domestic currency depreciates | Current account improves (NX rises) → helps BOP balance | Borrowers benefit; risk of asset‑price bubbles and higher debt levels, which can threaten sustainability. |
7. Time‑Lags in Monetary Policy
- Recognition lag – Time taken for policymakers to detect a change in inflation, output gap, or exchange‑rate pressure (usually a few months).
- Implementation lag – Time between the decision and the actual change in the policy rate (1–2 months, covering the OMO process).
- Impact lag – Time for the new rate to affect borrowing, spending, AD and finally output/inflation (typically 6–18 months).
Because of these lags, central banks often act pre‑emptively, basing decisions on forecasts rather than waiting for the full impact to be observable.
8. Advantages of Interest‑Rate Policy (AO2)
- Quick to implement once the decision is taken.
- Highly transparent – the policy rate is published and widely reported.
- Flexible – can be adjusted frequently in response to new data.
- Indirectly influences a broad range of variables (C, I, NX, exchange rate).
- Does not require direct fiscal spending, so it avoids increasing the government deficit.
9. Limitations and Evaluation (AO3)
- Liquidity trap – When rates are already very low, further cuts may not stimulate borrowing because firms and households are unwilling or unable to take on more debt.
- Time‑lag problem – The impact lag can mean policy is “too late” or overshoots the target, especially in volatile economies.
- Distributional effects – Higher rates benefit savers but hurt borrowers; lower rates can widen wealth gaps and encourage excessive borrowing.
- Exchange‑rate volatility – Interest‑rate moves can cause large swings in the currency, which may hurt export‑oriented sectors or fuel imported‑inflation.
- Coordination with fiscal policy – Monetary policy alone may be insufficient; without supportive fiscal measures the desired impact on AD may be muted.
- Interest‑rate insensitivity – If confidence is low or balance sheets are already weak, changes in rates have a limited effect on C and I.
- Asset‑price bubbles – Prolonged low rates can inflate housing or equity markets, creating long‑run sustainability risks.
10. Sample Exam Question (8 marks) & 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.
Mark scheme (summary):
- State that a higher policy rate leads commercial banks to raise their lending rates. (1)
- Explain that higher borrowing costs reduce consumer credit and firm investment. (2)
- Note that a higher return on deposits encourages households to save rather than spend. (1)
- Identify the likely appreciation of the domestic currency and the consequent fall in net exports. (1)
- Combine the above to show that C, I and NX all fall, so AD falls. (2)
- Conclude that, ceteris paribus, output and employment are likely to fall in the short run. (1)
11. Key Take‑aways
- Interest‑rate policy is the primary monetary‑policy tool for most IGCSE economies, but it works alongside money‑supply operations and foreign‑exchange intervention.
- Changes affect the economy through borrowing‑saving decisions, investment, consumption, exchange rates and ultimately aggregate demand.
- The direction of the effect is predictable; the magnitude depends on the sensitivity of C, I and NX to interest‑rate changes.
- Policy makers must consider the three time‑lags, the state of confidence, and possible side‑effects such as distributional impacts and exchange‑rate volatility.
- In exam answers always: (a) link the rate change to the five macro‑economic aims, (b) draw the required transmission diagram, (c) evaluate both advantages and limitations.