IGCSE Economics 0455 – Government and the Macro‑economy: Monetary Policy
Government and the Macro‑economy – Monetary Policy
1. What is Monetary Policy?
Monetary policy is the set of actions undertaken by a country’s central bank to control the supply of money and the cost of borrowing (interest rates) in order to achieve macro‑economic objectives such as price stability, full employment, economic growth and a sustainable balance of payments.
2. Main Objectives of Monetary Policy
Control inflation (price stability)
Stimulate or restrain economic growth
Reduce unemployment
Influence the exchange rate and balance of payments
Maintain financial stability
3. Primary Monetary‑policy Instruments
The central bank can use three main tools. Their impact on the economy is shown in the table below.
Instrument
How it works
Typical effect on interest rates
Likely macro‑economic outcome
Open Market Operations (OMO)
Buying or selling government securities in the open market.
Percentage of deposits that banks must hold as reserves.
Reducing the ratio frees up funds → ↓ interest rates. Increasing the ratio ties up funds → ↑ interest rates.
Lower reserve ratio expands credit, stimulating demand; higher ratio restricts credit, dampening demand.
4. The Transmission Mechanism
The way monetary policy moves through the economy can be summarised in the following steps:
Central bank changes the policy instrument (e.g., lowers the discount rate).
Commercial banks’ cost of borrowing changes, altering the market interest rate.
Changes in interest rates affect:
Consumer spending on durable goods and housing.
Business investment decisions.
Exchange rate movements (through capital flows).
Aggregate demand (AD) shifts:
Expansionary policy → AD shifts right → higher output and price level.
Contractionary policy → AD shifts left → lower output and price level.
Macroeconomic outcomes (inflation, unemployment, growth) move towards the government’s targets.
5. How Monetary Policy Helps Achieve Specific Macro‑economic Aims
5.1 Controlling Inflation
When inflation is above the target, the central bank may adopt a contractionary stance:
Sell government securities (OMO) → reduce money supply.
Raise the discount rate → increase borrowing costs.
Increase reserve requirements → limit bank lending.
These actions raise interest rates, reduce consumer spending and investment, and shift AD left, easing price pressures.
5.2 Reducing Unemployment
In a recession with high unemployment, an expansionary policy is used:
Buy government securities → increase money supply.
Lower the discount rate → cheaper bank borrowing.
Reduce reserve requirements → more credit available.
The resulting fall in interest rates stimulates AD, raising output and employment.
5.3 Supporting Economic Growth
Growth can be sustained by maintaining a stable, low‑inflation environment while ensuring sufficient credit availability. A “neutral” monetary stance keeps interest rates at a level that neither overheats nor stalls the economy.
5.4 Improving the Balance of Payments
Monetary policy influences the exchange rate:
Contractionary policy → higher interest rates → capital inflows → currency appreciation → imports become cheaper, exports become more expensive → possible deficit.
Expansionary policy → lower interest rates → capital outflows → currency depreciation → exports become cheaper, imports more expensive → possible improvement in the current account.
6. Limitations and Challenges
Time lags: Recognition, implementation and effect lags can delay outcomes.
Liquidity trap: When interest rates are already near zero, further cuts may not stimulate borrowing.
Policy credibility: If markets doubt the central bank’s commitment, policy may be less effective.
Global influences: Exchange‑rate movements and capital flows can offset domestic policy actions.
Conflict of objectives: Reducing inflation may raise unemployment, creating a policy trade‑off.
7. Example Scenario
Suppose the UK is experiencing a 5 % inflation rate, above the target of 2 %. The Bank of England decides to adopt a contractionary stance.
It sells £10 billion of gilts in the open market.
The money supply contracts, causing the Bank Rate to rise from 0.5 % to 1.5 %.
Higher rates discourage borrowing for houses and cars, reducing consumer spending.
Business investment slows as financing costs rise.
Aggregate demand shifts left, easing pressure on prices and moving inflation back toward the 2 % target.
Suggested diagram: The AD–AS model showing a leftward shift of AD after a contractionary monetary policy, illustrating the movement from a higher‑inflation equilibrium to a lower‑inflation equilibrium.
8. Summary Checklist for Exams
Define monetary policy and name the central bank’s main objectives.
Identify the three primary instruments and describe how each affects the money supply and interest rates.
Explain the transmission mechanism from policy action to macro‑economic outcome.
Link each instrument to the specific macro‑economic aim it can help achieve (inflation, unemployment, growth, balance of payments).
Discuss at least two limitations of monetary policy.
Be able to sketch and label a simple AD–AS diagram illustrating expansionary and contractionary effects.