Revise Monetary policy for Cambridge 2281 (4.4)

Monetary policy involves actions undertaken by a country's central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity. Its primary objective is typically to maintain price stability (i.e., control inflation), while also aiming for secondary goals such as full employment and sustainable economic growth. The main instruments of monetary policy are the manipulation of interest rates, adjustments to the money supply (including unconventional measures like Quantitative Easing), and influencing the exchange rate. By altering the cost and availability of money, the central bank can influence aggregate demand (AD), thereby managing the trade-off between inflation and unemployment in the short run. The effectiveness of these policies is a subject of continuous debate among economists.

The cornerstone of modern monetary policy is the policy interest rate, often called the 'base rate' or 'Bank Rate' in the UK. This is the rate at which the central bank lends to commercial banks. A change in this base rate triggers a chain reaction. Commercial banks typically adjust their own lending and saving rates for households and firms in response. For example, a cut in the base rate usually leads to lower mortgage rates and cheaper business loans. This is because the central bank's rate acts as the foundational cost of funds in the banking system. Decisions on the base rate are usually made by a committee, such as the Monetary Policy Committee (MPC) in the UK, which analyses economic data to determine the appropriate level to meet its inflation target.

The transmission mechanism describes how a change in the central bank's policy rate filters through the economy to affect aggregate demand and inflation. There are several channels. A rate change directly impacts market rates, affecting the cost of borrowing for consumers and firms, which influences consumption (C) and investment (I). It also alters asset prices; lower rates can make bonds less attractive and equities more attractive, creating a positive wealth effect that boosts consumption. Furthermore, interest rate changes affect the exchange rate. Higher domestic rates attract foreign 'hot money' flows, causing the currency to appreciate, which makes exports more expensive and imports cheaper, reducing net exports (X-M). The combined effect of these channels determines the overall impact on aggregate demand.

Monetary policy can be either expansionary (loose) or contractionary (tight). Expansionary policy is used during a recession or period of low growth. The central bank lowers interest rates to encourage borrowing and spending, and discourage saving. This stimulates consumption and investment, shifting the AD curve to the right. The goal is to increase real GDP and reduce unemployment, though it risks causing demand-pull inflation. Conversely, contractionary policy is used to combat high inflation. The central bank raises interest rates to make borrowing more expensive and saving more attractive. This dampens consumption and investment, shifting the AD curve to the left. This helps to reduce inflationary pressure but can lead to lower economic growth and higher unemployment.

When the central bank cuts interest rates:

1. Consumption: cheaper mortgages and loans → C rises.
2. Investment: lower cost of capital → I rises.
3. Exchange rate: lower r → currency depreciates → X↑, M↓.
4. Asset prices: higher asset values → wealth effect → C rises.

Combined effect: AD shifts right.