1The idea in one paragraph

Borrowing has a price, and that price is the interest rate. A central bank can change it. When borrowing gets cheaper, households and firms borrow and spend more, so aggregate demand rises; when it gets dearer, they spend less and aggregate demand falls. That is monetary policy: one lever, pulled to move AD right when output is too low and left when prices are rising too fast. The rest of this subtopic is the machinery behind the lever, and the argument about how well it works.

2The central bank, and the two things it controls

Monetary policy is the use of the money supply and interest rates by the central bank to influence aggregate demand.

The central bank issues the currency, banks the government and the commercial banks, and takes the rate decision. It is not the government and not a high street bank. In our imaginary economy, the Central Bank of Brindal sets the rate, the Brindali government sets taxes and spending, and Brindal Savings & Loan is where a household keeps its account.

The money supply is all the money in the economy: notes and coins, plus the bank deposits people can spend. Most of it is deposits, which section 7 returns to. The rate the bank sets is what it charges commercial banks, called the base rate, discount rate or refinancing rate. They borrow at it, so mortgage and business loan rates move with it, and savings rates too.

These are not two levers but two ends of one. Put more money into the system and the price of borrowing falls; take money out and it rises. For now: more money means a lower interest rate, less money a higher one.

3What the central bank is trying to achieve

A low and stable rate of inflation. Not zero, and not merely low: steady, so households and firms can plan. Most central banks pursue this by inflation targeting — announcing a number, say 2% a year with a band either side, and moving the rate to keep inflation near it. The announcement is part of the policy: people who believe it stop expecting large price rises, and stop demanding pay rises to match. Figure 1 shows the aim.

Low unemployment. Cheaper borrowing raises spending, higher spending raises output, and firms producing more hire more workers.

Reducing business cycle fluctuations. The business cycle is the pattern of booms and recessions around an economy's trend. The bank leans against it: cutting when output falls, raising when the economy runs hot, so the swings are smaller.

A stable environment for long-term growth. A firm commits to a new factory only if it can guess what the next ten years look like. Steady prices and predictable rates make that guess possible, so investment is higher over time.

External balance. What a country buys from abroad staying roughly in line with what it sells, rather than a deficit year after year. A higher rate tends to strengthen the currency, making imports cheaper and exports dearer, and it cuts spending, some of which would have gone on imports.

These goals pull against each other, and saying so earns marks. Cut the rate to bring unemployment down and the price level rises; raise it to protect the target and jobs go. The bank is always choosing which goal to serve now.

4Real versus nominal interest rates

The advertised figure is the nominal interest rate. It says nothing about what the money will buy. The real interest rate corrects for that.

Real interest rate = nominal interest rate − rate of inflation.

Brindal Savings & Loan pays 6% and inflation is 4%. Put 2,000 in for a year and you get 2,120 back, but everything costs 4% more, so your 2,120 buys what 2,120 ÷ 1.04 ≈ 2,038 bought last year. You are about 2% better off in what you can buy, and 6 − 4 = 2 gives that in one step.

Change one number. The nominal rate is still 6%, inflation turns out to be 9%, and the real rate is 6 − 9 = −3%. Your balance grew and you can buy less than before. Figure 2 sets the two years side by side.

Two consequences, both examinable. Borrowers and lenders decide on the real rate: a firm borrowing at 6% cares whether the price of what it sells will rise by 4% or by 9%. And a bank can cut the nominal rate while tightening — from 6% to 5% as inflation falls from 4% to 1% takes the real rate from 2% to 4%, so borrowing got dearer even though the poster figure went down.

5How a change in the interest rate reaches aggregate demand

This chain is the heart of the subtopic. Each arrow is a link you must say out loud; "interest rates fall so AD rises" skips everything being marked.

The bank cuts its rate and commercial banks follow. Loans cost less; savings pay less. Then three components of AD respond.

• Consumption (C) rises. Households with mortgages have more left each month, a car loan becomes affordable, and saving now pays so little that spending looks better by comparison.
• Investment (I) rises. Investment is firms' spending on capital: machines, buildings, vehicles. An Brindali bakery is weighing a second oven that would return 7% a year. At a borrowing cost of 9% it is not worth it; at 5% it is. Every cut turns some rejected projects into accepted ones.
• Net exports (X − M) rise. A lower rate makes the currency less attractive to hold, so it tends to weaken, making exports cheaper abroad and imports dearer at home.

So AD rises and the curve shifts right. G has not changed; the other three have, and AD is their sum. Firms meet the extra demand by producing more and hiring more, and that demand also pulls prices up.

Run it backwards for a rate rise and every link reverses: C and I fall, the currency strengthens, net exports fall, AD shifts left, output and the price level fall.

6Expansionary and contractionary monetary policy

Expansionary monetary policy lowers the interest rate and raises the money supply to increase AD. It is used against a deflationary gap, also called a recessionary gap: equilibrium real output below Yf, with unemployment and downward pressure on prices. In Figure 4, AD₁ crosses SRAS left of Yf, and the policy pushes it right to AD₂, where output reaches Yf.

Notice the cost of the cure: the price level rises from PL₁ to PL₂. Closing a gap this way is never free, and saying so is an evaluation point rather than a mistake.

Contractionary monetary policy raises the rate and reduces the money supply to lower AD. It is used against an inflationary gap: equilibrium output above Yf, which an economy can sustain only by bidding up wages and prices. Figure 5 shifts AD left until output returns to Yf and the price level falls back.

One rule keeps these diagrams right, and it is the sentence to memorise here.

Monetary policy moves the AD curve. If your diagram moves an AS curve, you have drawn a different policy.

That is what "demand management" in the title means: the target is aggregate demand, and the AS curves stay where they were.

10How well does monetary policy work?

Part (b) marks live here, and a list of advantages followed by a list of disadvantages is not evaluation. A judgement that depends on something is.

It is incremental, flexible and easily reversible. The bank can cut by a quarter of a point, watch, cut again, or reverse at the next meeting. Compare a government trying to un-build a hospital.

Its decision lag is short. A committee meets and the rate changes that day, with no vote in parliament — a real advantage over fiscal policy. Be careful with "lag" though: the decision is quick, while the effect on spending and jobs takes months, because households refinance and firms build slowly.

Constraint: there is a floor under the interest rate. A rate already near zero cannot be cut much further, so in a deep recession the bank runs out of room. Figure 8 shows an economy at that point.

Constraint: low consumer and business confidence. A cheap loan is only taken by someone who wants to borrow. Households who fear for their jobs use a lower rate to pay off debt, not to buy a car, and firms expecting weak sales will not build a factory at any rate. The chain in Figure 3 breaks at its first link.

Now the judgement, goal by goal. Against inflation the policy is strong: there is no ceiling on the interest rate, so a determined bank can always raise it far enough to bring AD, and demand-pull inflation with it, down. The cost is that the same rise takes output and jobs with it. For growth and against unemployment it is weaker, and weakest when most needed: a cut works in a mild slowdown, but in a deep recession both constraints arrive together, rates near zero and confidence low, so the bank is pushing on something that will not move. That is where 3.6 fiscal policy has the stronger claim, because a government that spends is not waiting for anyone else to be willing.

So the answer depends on direction. Slowing an economy is something a central bank can do almost at will; speeding one up needs somebody at the other end who wants to borrow.