Monetary policy
Key terms:
Monetary policy - a demand-side policy with the Central Bank using changes in the
money supply or interest rates to affect AD.
Central bank - the governments bank and has ultimate control over the supply of money
in the economy e.g. The Federal Reserve Bank.
Base rate or discount interest rate - the interest rate that Central banks charge
commercial banks for short term loans. This is used by governments to influence interest
rates in the economy. If a Central bank lowers the rate at which lends money to
commercial banks then this should also be passed onto to consumers in the form of lower
rates.
Expansionary monetary policy - an expansion of the money supply through reduced
interest rates and / or quantitative easing. This is used to stimulate the economy by
reducing the cost of borrowing, which in turn encourages private consumption and
investment.
Contractionary monetary policy - a contraction of the money supply through higher
interest rates and / or lowering the money in circulation. This is used to fight inflation by
increasing the cost of borrowing, which in turn decreases GDP and dampens inflation.
Quantitative easing - another example of expansionary monetary policy and can be used
when short-term interest rates are at or approaching zero. In QE a central bank
purchases government securities or other securities from the market in order to increase
the money supply and encourage lending and investment.
© Mark Johnson,
InThinking www.thinkib.net/Economics
1
Beginning exercise
Suppose you are stuck on a desert island with your current class. You quickly pick up skills
to make life better on the island. Some of you become fishermen, farmers, hunters e.t.c while
a number of you learn how to build simple beach huts and become relatively wealthy
individuals. The collective value of your output is equal to the island GDP. You begin
trading with each other but quickly realise the limitations of a barter economy. You then get
together and collectively agree that the small, limited blue pebbles, which you can find on the
island will be used as currency. These are collected and placed in a central bank. The new
monetary system works well and the individual in charge of administering the pebbles is well
thought of. One day this individual decides that the economy needs a boost. He mixes some
blue die and colours a number of the white pebbles blue in what he hopes will be a boost to
the economy. Indicate the likelihood of this monetary venture being successful?
Activity 2: The money supply
(a) The diagram to the right illustrates the
market for money, with the price of
money equal to rate of interest in the
economy. Explain how during an
economic cycle the money market adjusts
to reflect economic conditions?
(b) Illustrate what happens to the market for money when the government increases the
supply of money in the economy by quantitative easing or reducing the reserve rate?
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InThinking www.thinkib.net/Economics
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Activity 3: Using monetary policy to close an output gap
Use the information in the video to complete the following tasks.
(a) The video claims that during recession the government may choose to implement
expansionary monetary policy to raise aggregate demand. Which three monetary policies
does it identify to satisfy this objective?
(b) How does lowering interest rates in the economy raise the money supply and increase
aggregate demand?
(c) Draw keynesian and classical / laissez faire LRAS curves, representing an economy with
a recessionary gap.
(d) Illustrate the effect of expansionary monetary policy on the two diagrams you have
drawn?
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InThinking www.thinkib.net/Economics
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(e) Draw keynesian and classical / laissez faire LRAS curves, representing an economy with
an inflationary gap.
(f) Explain the effect of contractionary monetary policy on the two diagrams you have
drawn?
(g) Explain what happens to either an inflationary or contractionary gap when the
government chooses not to intervene.
(h) Why did William McChesney Martin, former chairman of the Federal Reserve say that
the job of monetary policy was to get a party started before 'taking away the punch bowl'
© Mark Johnson,
InThinking www.thinkib.net/Economics
4
Activity 4
The following data relates to the UK in 2024:
The average house price in the country was $ 400,000 and average incomes were $ 2,900 per
month net of tax.
Complete the following table by filling in the missing blanks:
Mortgage interest
rate
Size of loan (UK
average)
4%
5% (current)
6%
7%
$ 200,000
$ 200,000
$ 200,000
$ 200,000
Monthly
instalments
(interest only)
Disposable income
(net income mortgage payment)
Use the above data to evaluate the statement that control of interest rates is one of the most
significant economic weapons that a government possesses in its control of national income.
Activity 5: The limitations of monetary policy
Use the information from the following video to answer the questions that follow:
(a) What difficulties does any central bank have in taking the correct course of action to
reduce the size of an output gap in the economy?
(b) What are the risks of central banks getting monetary policy wrong?
© Mark Johnson,
InThinking www.thinkib.net/Economics
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Activity 6: Money multiplier
The following video focuses on the multiplier - the first 3.50 minutes on the spending
multiplier but the remainder of the video focus on the money multiplier. Use the information
from the video to answer the questions about the money multiplier.
(a) What is the money multiplier?
(b) The reserve requirement in an economy is 10%. Calculate the total rise in the money
supply created when the government purchases $10 billion worth of bonds.
(c) Using the same reserve requirement what would be the total fall in the money supply
when the government sells $ 15 billion worth of bonds.
(d) A government decides to reduce the reserve requirement from 10% to just 7. Is this an
example of expansionary or contractionary monetary policy?
Activity 7: Link to the assessment in paper one
Examples of paper one questions on monetary policy include:
(a) Illustrate using a diagram how a government can use expansionary monetary policy to
close a deflationary gap in the economy. [10 marks]
(b) Using examples from the real world, discuss why Keynes believed that an economy will
remain stuck in a permanent deflationary gap, without the use of a government fiscal stimulus
package. [15 marks]
© Mark Johnson,
InThinking www.thinkib.net/Economics
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