Government and the Macro‑economy – Monetary Policy (Cambridge IGCSE 0455)
1. Key Definitions (Syllabus 4.3.1)
- Money supply (M): the total amount of cash and bank deposits that are available for spending in the economy.
- Monetary policy: the set of actions taken by a country’s central bank to influence the money supply, the interest rate (and, where relevant, the exchange rate) in order to achieve the government’s macro‑economic objectives (price stability, full employment, sustainable growth and a balanced current account).
- Central bank: the institution that controls a nation’s monetary policy (e.g. the Bank of England, the Federal Reserve, the European Central Bank).
2. Main Objectives of Monetary Policy (Syllabus 4.3.2)
- Maintain price stability – keep inflation close to the target (usually around 2 %).
- Promote full employment – keep unemployment as low as possible without fuelling inflation.
- Support sustainable economic growth – a steady rise in real GDP.
- Help achieve a balanced current account – avoid large deficits or surpluses.
- Preserve financial‑sector stability (often included in the syllabus as a supporting aim).
3. Monetary‑policy Measures (Syllabus 4.3.2)
The central bank can influence three inter‑related variables:
- The interest rate (policy/discount rate).
- The money supply (through open‑market operations and reserve requirements).
- The exchange rate (by direct market intervention or indirectly via interest‑rate changes).
4. Primary Instruments and Their Effects
| Instrument | How it works | Effect on money supply | Effect on interest rate | Typical macro‑economic outcome |
|---|
| Open‑Market Operations (OMO) | Buying or selling government securities in the open market. | Buy → money supply ↑ Sell → money supply ↓ | Buy → market rates ↓ Sell → market rates ↑ | Expansionary OMO → AD shifts right (higher output, possible inflation).
Contractionary OMO → AD shifts left (lower inflation, slower growth). |
| Discount (Policy) Rate | Rate at which commercial banks can borrow from the central bank. | Change does not directly alter the money supply but influences banks’ willingness to lend. | Lower rate → market rates ↓ Higher rate → market rates ↑ | Lower rate encourages consumption & investment (expansionary).
Higher rate restrains demand (contractionary). |
| Reserve Requirements (Cash Reserve Ratio) | Percentage of deposits that banks must hold as reserves. | Reduce ratio → banks can lend more → money supply ↑.
Increase ratio → lending falls → money supply ↓. | Lower ratio → pressure on rates to fall.
Higher ratio → pressure on rates to rise. | Changes affect the amount of credit, shifting AD in the same direction as the change in money supply. |
| Foreign‑exchange Intervention | Buying or selling foreign currency to influence the domestic exchange rate. | Intervention usually involves a change in domestic money supply (e.g., selling foreign currency for domestic currency reduces money supply). | Appreciation pressure → rates tend to rise.
Depreciation pressure → rates tend to fall. | Appreciation makes imports cheaper and exports costlier (possible current‑account deficit).
Depreciation makes exports cheaper and imports costlier (possible current‑account improvement). |
5. The Transmission Mechanism (How Policy Moves Through the Economy)
- Central bank changes an instrument (e.g., lowers the discount rate).
- Commercial banks’ cost of borrowing changes, leading to a change in the prevailing market interest rate.
- Changes in interest rates affect:
- Consumer spending on durable goods and housing.
- Business investment decisions.
- Saving behaviour.
- Exchange‑rate movements through capital‑flow responses.
- These behavioural changes shift the Aggregate Demand (AD) curve:
- Expansionary policy → AD shifts right.
- Contractionary policy → AD shifts left.
- The new equilibrium influences the government’s macro‑economic aims (inflation, unemployment, growth, balance of payments).
6. How Monetary Policy Helps Achieve Specific Macro‑economic Aims
6.1 Controlling Inflation
When inflation is above the target, a contractionary stance is adopted:
- Sell government securities (OMO) → money supply falls.
- Raise the discount rate → borrowing becomes more expensive.
- Increase reserve requirements → banks can lend less.
- Possibly intervene to support the domestic currency → higher rates.
Result: Higher interest rates curb consumer spending and business investment, AD shifts left, and price pressures ease.
6.2 Reducing Unemployment (Stimulating Output)
In a recession with high unemployment, an expansionary stance is used:
- Buy government securities (OMO) → money supply rises.
- Lower the discount rate → cheaper bank borrowing.
- Reduce reserve requirements → more credit available.
- Allow the exchange rate to depreciate (or intervene to weaken it) → export demand rises.
Result: Lower interest rates stimulate consumption and investment, AD shifts right, output and employment increase.
6.3 Supporting Sustainable Economic Growth
A “neutral” monetary stance keeps interest rates at a level that neither overheats nor stalls the economy. The central bank monitors inflation expectations and adjusts instruments gradually to maintain a stable environment for long‑term growth.
6.4 Improving the Balance of Payments
Monetary policy influences the exchange rate, which in turn affects the current account:
- Contractionary policy: higher rates attract capital inflows → currency appreciates → imports become cheaper, exports become costlier → current‑account deficit may widen.
- Expansionary policy: lower rates trigger capital outflows → currency depreciates → exports become cheaper, imports become costlier → current‑account surplus may improve.
7. Limitations and Challenges (Syllabus 4.3.3)
- Time lags: Recognition, implementation and effect lags mean policy actions may take months to influence the real economy.
- Liquidity trap: When rates are already near zero, further cuts may not stimulate borrowing.
- Policy credibility: If markets doubt the central bank’s commitment to its target, expectations can offset the intended effect.
- External shocks: Global interest‑rate movements, commodity‑price swings or sudden capital‑flow reversals can undermine domestic policy.
- Objective conflict: Reducing inflation often raises unemployment (the “inflation‑unemployment trade‑off”).
- Exchange‑rate volatility: Direct intervention can be costly and may provoke retaliation.
8. Example Scenario – Exam‑style Question
Situation: The United Kingdom is experiencing inflation of 5 % (target 2 %). The Bank of England decides on a contractionary stance.
- It sells £10 billion of gilts in the open market.
- Money supply contracts and the Bank Rate rises from 0.5 % to 1.5 %.
- Higher rates discourage borrowing for houses, cars and business projects.
- Consumer spending and business investment fall, shifting AD left.
- Price pressures ease and inflation moves back toward the 2 % target.
Diagram suggestion: AD–AS diagram showing a leftward shift of AD from point A (higher‑inflation equilibrium) to point B (lower‑inflation equilibrium). Label the axes, curves, and both equilibrium points.
9. Summary Checklist for Exams (Syllabus 4.3.4)
- Define money supply and monetary policy using the exact syllabus wording.
- State the four main objectives: price stability, full employment, sustainable growth, balanced current account.
- List the three monetary‑policy measures: interest rate, money supply, exchange rate.
- Identify the four primary instruments (OMO, discount rate, reserve requirements, foreign‑exchange intervention) and explain how each changes the money supply and interest rates.
- Describe the transmission mechanism from a policy change to its impact on AD and the macro‑economic variables.
- Link each instrument to the specific macro‑economic aim(s) it can help achieve (inflation, unemployment, growth, balance of payments).
- Discuss at least two limitations (e.g., time lags, liquidity trap, credibility, external shocks, objective conflict).
- Be able to draw a labelled AD–AS diagram showing both expansionary and contractionary monetary‑policy effects.