Monetary policy concerns three main methods of government intervention in an economy. These are changes in the money supply, the rate of interest and the exchange rate, and are covered in more detail below. They are grouped like this as they directly affect aggregate demand (but also indirectly affect supply in a variety of ways).
This does exactly what it says on the tin! A government can increase the money supply by printing money or providing incentives for banks to increase the lending of money (not changing interest rates). This results in an increase in the amount of disposable income people will have to spend on goods and services. This shifts aggregate demand, as AD = C + I + G + (X - M) , with consumer spending represented by 'C'.
Consequences of changing the Money Supply
- Since increasing the money supply can affect AD, then ceteris paribus (cp.) inflation in prices will result at the same time as an increase in output, as can be shown on any demand and supply diagram. A central bank must decide whether the benefits of demand-side economic growth outweigh the costs of potential demand-pull inflation.
- This resultant inflation could cause the currency to depreciate against others, as fewer goods and services can be bought for the same nominal amount of money. This means that the exchange rate is lower, increasing the price of imports and increasing the competitiveness of exports with their associated effects on the economy!
This is the major method of monetary policy used today, although this was not always the case. The rate of interest is a return on savings set by the national bank, meaning that if an individual saves a sum of money in a bank, they will receive a rate of interest similar to that set by the central bank. Because of this, a change in the rate of interest will result several macroeconomic effects. A rise in interest rates will:
- reduce consumption and investment, and consequently AD. This is due to the fact that individuals and firms will be more inclined to save wages and profits than invest or spend them, as the return on saving per year is greater
- raise the cost of borrowing from banks, as the rate of interest on repayments is greater. This could further reduce spending and investment
- encourage foreign investment in domestic institutions and firms to increase, as a high rate of return on savings is attractive. High demand for the currency will raise its value (like any other product). This would lead to an increase in the price of exports and a fall in the price of imports, resulting in an increase in imports and fall in exports as they are less competitive globally. This would lead to a fall in AD ( X - M )
The major purpose of a rise in interest rates is to 'cool down' an economy that is overheating ie. to reduce inflationary pressure due to high aggregate demand and no complementary increase in long run aggregate supply.
The exact opposite applies to a fall in interest rates. A cut in interest rates is often used to aid economic recovery and boost consumer demand, make exports more competitive, and encourage capital investment by firms.