Monetary Policy

 The use of economic policy instruments such as interest rates, money supply,
exchange rate etc to affect the aggregate demand of an economy.
 Interest rates measure the cost of borrowing.
o Base rate – set by the bank of England
currently at 4.5%
o lending rate – cost of borrowing
determined by lenders.
 interest rate transmission mechanism
o Decisions about that official interest rate
affect economic activity and inflation
through several channels.
 Effects of an increase in interest
o Households
 Less incentive to borrow, people will have to pay more to lenders due to the
amount that needs to be paid back increasing. Decreased MPC.
 Would cause an increase in withdrawals, households will be more likely to save
money as higher interest rate means their savings will increase. Increased MPS.
o Firms
 Capital goods will be worth more because of an increase in interest.
 Sales of goods and services will decrease, as consumers won’t be able to buy as
much of each product as consumers are saving more due to the increase in
interest meaning when they save their savings will increase.
o External economy
 Incentive to save in Britain by foreigners will increase.

Effectiveness on interest rate affecting macro-economic objectives.

 If there is a decrease in interest, there will be a higher incentive to borrow from
lenders. Lower amount will need to be paid back, causing an increase in MPC.
 Increase in MPC causes an increase in consumption, component of AD
which causes it to shift to the right
 Decrease in withdrawals, households are less likely to save as their savings won’t
increase as much. Decrease in MPS.
 Capital goods will be worth less, lower interest means value doesn’t appreciate as
much.
 Lower incentive to save by foreigners.

Interest rate targeting

 Interest rates – the cost of borrowing
 Inflation targeting – when a figure is set by the government or the central bank as a
guide to changes in the general price level of an economy.
o Benefits of inflation targeting
 Helps to maintain price stability, affordable prices help an economy to
become more competitive and efficient in producing goods and
services.
  Helps to lower inflation.
 Greater transparency and accountability for firms
 Low and stable prices communicate to firms that prices of raw
materials will not rise/fall drastically. Therefore, promotes
firms to invest/continue with normal production confidently.
 Flexibility if it is a symmetric target.
 Exchange rate
 Value of a currency compared to another.
 Devaluation – the fall in the price of a currency compared to another
currency.
 When exchange rate falls,
 Price of exports falls, leading to increased demand for exports,
as the cost to the consumer will decrease.
 Price of imports will rise because the economy will spend less.
The same item that cost €116 but £100 was needed now
needs £105.45 leading to a reduced demand and therefore
increased price for imports.
 Marshall–Lerner condition
 For a devalued currency to raise X and drop M, the sum of the elasticities of
M and X must be elastic.
 Evaluation of a currency devaluing using a J curve