Monetary Policy
- Monetary policy is the central bank and/or government decisions on the rate of interest, the money supply and the exchange rate
- Both monetary and fiscal policies are known as demand-side policies, as they both seek to influence AD
- The main monetary policy used is the rate of interest
- When a central bank increases is short term interest rate (base rate), commercial banks usually follow suit
- A higher interest rate lowers consumption and investment, and increases foreigners likeliness to put money into UK financial institutions, due to higher returns
- This increase in demand for the pound increases its exchange rate of the pound, which makes exports more expensive and imports cheaper
- And this, ladies and gentlemen, will reduce net exports.
- So, overall, a rise in the interest rate is likely to decrease AD by reducing consumption, investment and net exports.
- However, a rise in the interest rate could lead to the exchange rate falling, as foreigners may be concerned about the economy’s growth prospects, and hence move their funds to other countries.
- Changes in the money supply can also influence AD
- Increasing it (e.g. printing more money or making it easier for banks to lend money) will increase AD
- The money supply has an inverse relationship with the interest rate
- Whereas some economist define monetary policy to only control the change in the rate of interest and money supply, it can be extended further to include changes in the exchange rate
- The currency can be devalued by either reducing the interest rate, or by selling pounds
- This reduction in the exchange rate would be done to achieve a more favourable current account position of the balance of payments.