3.4.2 Managing the National Economy
Monetary Policy, the Money Supply and Interest
Rates
With reference to the 10 year time line drawn previously take it
in turns to make one change in monetary policy and explain the
impact.
Where possible use diagrams to support your explanation.
How would you describe the current government’s attitude to
monetary policy?
AQA ECON4: T HE NATIONAL
AND INTERNATIONAL ECONOMY
M ONETARY P OLICY,
AND
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
M ONEY S UPPLY
I NTEREST R ATES
THE
You should be able to build on your knowledge of the role of
the Monetary Policy Committee (MPC) of the Bank of England
from Unit 2 and be able to discuss how the Bank can influence
the money supply (including quantitative easing) and the rate
of interest. In particular, you should be aware of the objectives
of monetary policy
You should be able to identify and explain the instruments of
policy which are currently employed by the Bank of England to
achieve the inflation target set by the government
You should understand how the demand for, and supply of,
funds in different markets affect interest rates
You should have an understanding of the factors considered by
the MPC when setting interest rates
Note: knowledge of the credit multiplier and liquidity preference
theory is not expected
M ONETARY P OLICY - R ECAP
Key points and terms to remember from ECON2 are:
 Definition

Test yourself!
Can you draw
2 diagrams to
show the
impact of
expansionary
and
contractionary
monetary
policy on an
economy?

Expansionary monetary policy
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
“The manipulation of the rate of interest, the money supply and
exchange rates to influence the level of economic activity”
This is associated with low interest rates, an expanding money
supply and a weak exchange rate to counteract deflationary
pressure and promote economic growth
Contractionary monetary policy

This is associated with high interest rates, a tight money supply
and a strong exchange rate to counteract inflationary pressure
and constrain economic growth that might stimulate inflation
M ONETARY P OLICY O BJECTIVES
Monetary policy has two primary objectives:
1. Maintaining a low and stable rate of inflation
2. Helping to promote stable economic growth and low
unemployment
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Historically, it is generally viewed that the first of these
objectives is the most important. The government has set the
Bank of England a target of 2% for inflation
However the financial crises of 2008-2012 and subsequent
recession, has highlighted the importance of the 2nd objective
and the role the Bank of England can play
In addition to these objectives, monetary policy through the
Bank of England may also:
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Enhance credibility
Manage expectations
Improve international competitiveness
M ONETARY P OLICY – K EY T ERMS
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Interest Rates
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Money Supply
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The reward for saving and the cost of borrowing
In effect, it is the ‘price of money’
There are a number of different definitions of the
money supply – see later slide
Exchange Rates

The price of one currency in relation to another
currency
T HE F UNCTIONS

Money is simply any
asset that is
acceptable to both
parties in any
transaction.
Money allows us to save for the future and delay current
consumption without fear that it will not be accepted in the
future
Unit of account
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This is often considered to be the prime function of money
It allows economic agents to exchange goods and services
without barter
Store of wealth

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M ONEY
Medium of exchange
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OF
Money allows economic agents to compare different goods and
services in terms of value and compare relative prices
Standard of deferred payment

Money allows consumers and firms to purchase goods and
services on credit, and pay for them at some time in the future
T HE M ONEY S UPPLY
The money supply is very difficult to define precisely because there
are a number of assets that may perform the functions of money,
but in differing degrees
 General definition
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Narrow money
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Notes and coins and cash balances used as a daily medium of
exchange
Broad money
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“Total amount of money circulating in an economy”
Cash held in banks that cannot be immediately accessed e.g.
notice accounts, treasury bills and gilts
Liquidity

The ease with which a financial asset can be turned into cash
T HE L IQUIDITY S PECTRUM
Broad Money
Narrow Money
Cash
Current A/c’s
Notice A/c’s
Treasury Bills
Property
Increasing liquidity (right to left)

Alongside interest rates and the exchange rate, the money supply is a major
tool of monetary policy, however, as the liquidity spectrum and money
supply definitions show, the money supply is very difficult to control with any
accuracy

Because of the difficulty in defining “money” and the issues of varying
degrees of liquidity of different assets, the money supply is often seen as an
economic indicator, rather than a monetary policy tool However for ECON4
you still need to understand the implications of an expanding or shrinking
money supply
T HE D EMAND
The demand for
money is
determined by two
key factors:
1.
Income
2.
Rate of Interest
The demand for
money is downward
sloping, because as
interest rates fall,
holding money
becomes less
attractive.
Interest
Rate
FOR
M ONEY
For example, if incomes rise, then
individuals will want to hold more
money so they can engage in more
transactions.
Equally, if interest rates rise, then
individuals have an incentive to hold
money in accounts that yield a higher
return because the opportunity cost
of holding money has increased.
Dm2
Dm1
Quantity of Money
T HE M ONEY S UPPLY
AND
I NTEREST R ATES (1)
It is assumed that the money supply
is fixed in the short-run.
Interest
Rate
r2
MS
As a consequence, if there is an
increase in the demand for money,
then interest rates will rise from r1 to
r2.
r1
Dm2
Dm1
Quantity of Money
T HE M ONEY S UPPLY
Interest
Rate
r1
Draw a
diagram to
illustrate how a
contraction in
the money
supply would
have the effect
of increasing
interest rates.
MS
MS1
AND
I NTEREST R ATES (2)
If we assume that the Bank of
England has the ability to control the
money supply, then an increase in the
money supply will shift MS to MS1.
If the demand for money remains
unchanged, then the interest rate will
fall from r1 to r2.
r2
Dm
Quantity of Money
T HE M ONETARY T RANSMISSION M ECHANISM
It is important to
understand
exactly how the
MTM works as
this will enable
you to understand
more fully the
process behind
monetary policy
and its
effectiveness.
Source: Bank of
England
Market
rates
Domestic
demand
Asset
prices
Official
interest
rate
Total
demand
Net
external
demand
Domestic
inflationary
pressure
Inflation
Import
prices
Expectations
/confidence
Exchange
rate
N OMINAL V R EAL I NTEREST R ATES
Nominal interest rates
 The core interest rate determined by the
BoE
Real interest rates
 These take inflation into account, and are
considered more important for businesses
and consumers
 For example, if the rate of interest on
savings is 3%, but inflation is 2%, then the
real rate of interest is only 1%
T HE MPC
AND I NTEREST
R ATES
The MPC meet each month to decide the UK base rate of interest. When making a
decision, they factor in a large range of available data for consideration, including:
Demand and output
 Data on overall consumption and investment spending by firms as well as output gap
estimates, which have a significant bearing on demand-pull inflationary pressures
The labour market
Interest rates:
Bank policymakers
split 7-2 over rise.
 Employment and wage data, which has a significant bearing on cost-push inflationary
pressure
Costs and prices
 Data is gathered on commodity prices and manufacturing costs; often known as
“factory gate” prices
Money supply and credit
 Data on total bank lending e.g. credit cards, personal loans and mortgages and the total
estimated value of consumer debt
Financial markets
 The BoE will monitor share prices, the value of pension portfolios and others, which
impact upon wider confidence
International economy
 The European and global economic environment in terms of economic growth, stability
and polices of other countries in addition to monitoring the exchange rate, all of which
will impact upon international trade and confidence
Q UANTITATIVE E ASING (QE)
TASK:
You should have
an
understanding of
how QE works in
more detail.
Research the
mechanism by
which the BoE
can boost the
money supply,
and assess the
impact of QE on
the UK economy
since 2009.
 The global financial crisis of 2008 led to a significant re-think of the use
of monetary policy in the UK as demand collapsed as the “credit crunch”
began to have a global effect
 With interest rates at 0.5%, and the risk of deflation considered quite
high due to a sudden fall in aggregate demand, the BoE had to consider
an alternative way to stimulate the economy as it is very difficult, if not
impossible, for interest rates to fall any further
 QE works by the BoE purchasing government bonds (with electronically
generated cash) and other assets from institutions (generally commercial
banks and insurance companies). This then gives the seller of these
assets an injection of cash, which can be filtered through the banking
system to create a boost to the money supply through the greater
availability of credit
 Given that banks have now sold some of their assets, they will seek to
replace them with loans to individuals and firms, which are counted as
assets to a bank
 This process was begun in January 2009 and to date has totalled £375bn
in the UK
K EY C RITICISMS , L IMITATIONS AND
E VALUATION OF M ONETARY P OLICY
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Principally manages the demand-side of the economy, and tends to have a
limited effectiveness when dealing with supply-side shocks
The success depends upon the accurate forecasting of the effects of a wide
range of factors. Policy changes themselves can take 18-24 months to fully
work through the MTM
Liquidity Trap – when a cut in interest rates fail to stimulate economic activity,
e.g. because of low confidence. As a result, interest rates have recently been
viewed by some economists as a limited tool
In reality, it is very difficult to control many objectives with one primary tool
i.e. interest rates, whilst there is mixed evidence on the “success” of QE and
money supply measures
Changing interest rates has an effect on the exchange rate, which may or may
not be desirable depending if you are an importer or exporter
Interest rates may affect some parts of the economy more than others. e.g.
higher interest rates = good for savers, but hits people with mortgages
Inflation is low and has generally fluctuated around the target rate of 2% in
recent times, but it could be argued that this is partly due to global pressures
keeping inflation low. e.g. globalisation, rather than the effectiveness of the
Bank of England
C URRENT O VERALL F RAMEWORK
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MPC is independent
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Monetary policy is pre-emptive
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It is not subject (theoretically) to political pressure,
which should make low and stable inflation more
likely to be maintained, which is enhanced through its
independence and accountability
The very nature of the MPC is to be proactive, rather
than reactive when combating inflationary or
deflationary pressures
MPC have reduced inflation expectations

In general economic agents have enhanced
confidence that inflation will remain low, which the
Bank of England has attempted to promote through
Forward Guidance
10 QUESTIONS IN 10
MINUTES – ARE YOU READY ?
1. Monetary policy uses interest rates, the money supply and which other tool to
manipulate the economy?
2. What does QE stand for?
3. Contractionary monetary policy is associated with high interest rates and which
other two characteristics to counteract inflationary pressure?
4. What is the general definition of the money supply?
5. State 2 functions of money.
6. State 1 broad form of money.
7. State 1 narrow form of money.
8. What is the relationship between the demand for money and interest rates?
9. What does MTM stand for?
10. What is the difference between core and nominal interest rates?
End