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Monetary policy

Monetary policy: Use of interest rates and the money supply to influence the level of overall demand in the economy.

The money supply means all the money in the economy: notes and coins, plus money held in bank accounts. Like fiscal policy, monetary policy is used to manage aggregate demand, but it works through borrowing and saving instead of taxes and government spending.

Interest rates

Interest rates: The cost of borrowing and the reward for saving.

An interest rate is normally shown as a percentage of the amount borrowed or saved. Households and firms pay for some of their spending with borrowed money, so when interest rates change, their spending changes too.

There are many different interest rates in an economy. For example, credit cards usually charge far more than mortgages, because a mortgage is secured against a house. Banks also pay savers less than they charge borrowers, which is how they make a profit.

The role of central banks in setting interest rates

Central bank: The monetary authority that manages a country’s money supply and interest rates.

How central banks set interest rates:

• The base rate: the central bank sets the base rate, the rate it charges commercial banks for overnight loans. Other interest rates, e.g. on loans, mortgages and savings, usually move in line with it.
• An inflation target: in many countries, the government gives the central bank an inflation target, e.g. 2%. The central bank then chooses an interest rate that should hold inflation near that target.
• Other objectives: the central bank may also look at economic growth and unemployment when deciding on the base rate.

For example, the European Central Bank (ECB) sets interest rates for the countries that use the euro, and in the UK, the Bank of England’s Monetary Policy Committee does this job.

The impact of changes in interest rates on macroeconomic objectives

How a change in interest rates affects consumers and businesses

When interest rates fall:

• Consumers borrow more: loans are cheaper, so people borrow to pay for things like cars, furniture and holidays.
• Mortgage payments fall: households with a mortgage pay less each month, leaving them more disposable income to spend.
• Saving is less rewarding: savers earn less interest, so people are more likely to spend than save.
• Firms’ costs fall: interest on their existing loans and overdrafts drops, which boosts their profits.
• Firms invest more: much investment is paid for with borrowed money, so cheaper loans and higher business confidence lead to more investment.
• The exchange rate may fall: exports become cheaper for foreign buyers and imports become dearer, so exporters sell more.

When interest rates rise, the opposite happens. Borrowing costs more, mortgage payments go up and saving becomes more attractive, so consumers spend less. Firms face higher costs and lower profits, become more cautious and cut back on investment.

The impact on each objective

• Inflation: higher interest rates reduce borrowing and spending and encourage saving. Aggregate demand falls, which eases demand-pull inflation. A higher rate may also raise the exchange rate, which makes imports cheaper and helps to bring inflation down.
• Unemployment: lower interest rates increase borrowing and spending by households and firms. Firms produce more to meet the extra demand, so they recruit more staff and unemployment falls.
• Economic growth: lower interest rates can help an economy out of recession. For example, after 2008, many central banks cut their base rates to close to zero to stimulate growth. However, there is often a time lag before cuts boost demand, spending also depends on confidence, and lower rates can lead to inflation.
• Current account: higher interest rates lower aggregate demand, so people buy fewer imports, which can reduce a deficit. But if the exchange rate rises as well, exports cost more abroad and imports cost less at home, which makes the current account worse.

Asset purchasing by central banks

Asset purchasing: When a central bank buys government bonds from commercial banks.

Asset purchasing is also known as quantitative easing. Central banks in the USA, the EU, the UK and Japan used it during the global recession, when very low interest rates were not enough to boost demand.

The central bank buys government bonds and other financial assets, so new money passes into the commercial banks’ accounts. The commercial banks can then use this extra money to give more loans to consumers and firms. More lending leads to more spending, so aggregate demand rises, which helps economic growth.

However, the central bank creates this money electronically, which is a bit like printing money, so asset purchasing can be inflationary.