A committee of a dozen people meets, changes one number by a quarter of a percentage point, and within a year mortgage payments, business investment, the exchange rate and the inflation rate have all moved. Monetary policy is the study of how that one number reaches all the way through an economy.
📚 What you need to know
Demand-side policies shift AD. There are two: monetary (the central bank) and fiscal (the government).
Monetary policy adjusts interest rates and the money supply to influence aggregate demand.
Expansionary (loose) policy cuts rates or expands the money supply, shifting AD right. Contractionary (tight) policy does the reverse.
The real interest rate is the nominal rate minus inflation. It is the real rate that drives borrowing and saving decisions.
Four tools: the base rate, open market operations, minimum reserve requirements and quantitative easing.
Commercial banks create money through fractional reserve lending, magnified by the credit multiplier = 1 ÷ reserve ratio.
The route from a rate change to inflation is the transmission mechanism, and it works through borrowing, asset prices, confidence and the exchange rate.
Where monetary policy sits
Both demand-side policies aim at the same target, aggregate demand, but they are run by different people with different timetables.
Feature
Monetary policy
Fiscal policy
Who decides
The central bank, usually independent of government
The government, through the budget
Main levers
Interest rates and the money supply
Government spending and taxation
How often
Reviewed several times a year, often eight
Usually set once a year in the budget
Main target
An inflation target, commonly 2%
Growth, employment, equity and the public finances
Real rates, not the headline number
The rate advertised in a bank window is the nominal rate. It tells you nothing on its own, because what matters is whether your money grows faster than prices do.
The rate that actually matters
Real interest rate ≈ nominal interest rate − inflation rate
WORKED EXAMPLE
Using the data, calculate the real interest rate in Year 2. [3]
Year
CPI
Nominal interest rate
Year 1
112.5
not given
Year 2
117.0
5.25%
Step 1: get the inflation rate from the CPI(117.0 − 112.5) ÷ 112.5 × 100= 4.5 ÷ 112.5 × 100 = 4.00%Step 2: subtract it from the nominal rate5.25% − 4.00% = 1.25%Real interest rate = 1.25%A saver’s money grows 5.25% in cash but only 1.25% in what it can buy.
This is why a central bank can be tightening policy while the nominal rate looks low. If inflation falls faster than the nominal rate, the real rate rises and borrowing gets more expensive even though nothing was announced.
Expansionary policy: cutting rates to lift demand
Lower interest rates make borrowing cheaper and saving less attractive. Households bring forward purchases of cars and houses; firms find more investment projects worth funding. Consumption and investment rise, so AD shifts right.
Growth rises and unemployment usually falls, but the price level rises too. Every expansionary answer must mention that side effect.
Contractionary policy: raising rates to cool demand
Raise the rate and everything runs backwards. Mortgage and loan repayments rise, so households have less discretionary income. Firms shelve investment projects. Higher rates also attract foreign money, the currency appreciates, exports become dearer and net exports fall. AD shifts left.
Inflation eases, but output falls and unemployment rises. Fighting inflation with rates always has a cost in jobs.
The transmission mechanism
A rate change does not touch prices directly. It travels through a chain, and each link takes time and depends on how people behave.
There are other routes too: cheaper credit raises house and share prices so owners feel wealthier, and lower rates weaken the currency so exports become more competitive.
🧩 Writing a transmission chain in an exam
Name the change. “The central bank cuts the base rate by 0.5 percentage points.”
Pass it to commercial banks. Market lending and saving rates follow the base rate down.
Pick a component of AD and explain the behaviour: cheaper mortgages raise consumption, or cheaper loans raise investment.
Reach AD. Say explicitly that AD shifts right, and by more than the initial change because of the multiplier.
Finish at the objectives. Growth up, unemployment down, inflation up, current account probably worse.
The four tools
The base rate is the everyday tool. The other three sit behind it, and quantitative easing only appears when rates are already near zero.
Tool
What the central bank does
Effect
Base rate
Changes the rate at which it lends to commercial banks
Sets the benchmark for every market rate, so borrowing and saving rates follow
Open market operations
Buys or sells government bonds using existing reserves
Buying injects cash and lowers rates; selling withdraws cash and raises them
Reserve requirements
Changes the share of deposits banks must hold rather than lend
A lower ratio lets banks lend more, so the money supply expands
Quantitative easing
Creates new electronic reserves and buys assets on a large scale
Raises bank reserves, lowers long-term rates and boosts lending capacity
The QE trap in exams. QE and open market operations look identical because both involve buying bonds. The difference is the source of the money: open market operations use existing reserves, while QE uses newly created ones. Say that and you have the mark.
How banks create money
Here is the part that surprises people. Most money in a modern economy is not printed by anyone. It is created by commercial banks when they lend, because the loan becomes a deposit somewhere else, which becomes the basis for another loan.
Each bank keeps a fifth and lends the rest. The bars shrink because 20% leaks out into reserves at every round.
The credit (money) multiplier
Credit multiplier = 1 ÷ reserve ratio
WORKED EXAMPLE
The reserve ratio is 20% and $250m of new cash is deposited. Calculate the credit multiplier, the eventual total of deposits, and the new money created. [3]
Step 1: the multiplier1 ÷ 0.20 = 5Step 2: total deposits$250m × 5 = $1,250mStep 3: new money created$1,250m − $250m = $1,000mMultiplier 5; deposits $1,250m; new money $1,000mRaise the ratio to 25% and the multiplier falls to 4, so the same cash supports only $1,000m of deposits. Higher reserves mean less money creation.
The theoretical multiplier is an upper limit, not a forecast. In practice banks hold spare reserves, some cash leaks out of the system, and above all people have to want to borrow. That gap between theory and reality is exactly what the next page is about.
💡 Exam tip
Never stop at “interest rates fall so AD rises”. Name the component — consumption, investment or net exports — and explain the behaviour behind it.
Include the exchange rate route. Lower rates weaken the currency, raising net exports; higher rates strengthen it, cutting them.
Say real interest rate when discussing incentives to save or invest, and show the subtraction if data is given.
Label the AD/AS diagram fully and mark the shift with an arrow. Two labelled AD curves and both equilibria.
Finish every policy answer at the macroeconomic objectives: growth, unemployment, inflation and the current account.
If asked about the money supply, use the multiplier formula rather than describing the rounds in words.
⚠ Common mix-up
Monetary and fiscal policy. Interest rates are the central bank; taxes and spending are the government.
Expansionary meaning “raise the rate”. Expansionary means cutting the rate to expand demand.
Nominal and real rates. A 6% nominal rate with 7% inflation is a negative real rate.
QE and open market operations. New money versus existing reserves.
Assuming the multiplier always works fully. Cash leakages and unwilling borrowers cut it well below 1 ÷ reserve ratio.
Forgetting the exchange rate. It is often the fastest-acting channel of the whole mechanism.
Up next: Evaluating Monetary Policy — where the neat chain above meets confidence, time lags and the zero lower bound.
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