Demand-Side Policies - Monetary
Economics: Edexcel A A Level, topic 4.1.2
Monetary Policy Committee and Interest Rates
The Monetary Policy Committee (MPC) sets the 'base rate' of interest for the economy. This is used by banks and other such institutions as a guide.
Impact of interest rate change
- The main way the central bank tries to achieve its inflation target (price stability target) is through interest rates and quantitative easing, which is when the central bank introduces new money into the money supply.
Effect of lowering the Bank Rate
- If the Bank Rate was lowered (the Bank Rate is the Central Bank interest rate, also sometimes known as the Base Rate), it should lead to a lower LIBOR (London Inter-bank Offered Rate). This is the rate at which commercial banks lend/borrow from each other.
- They then pass this on (in theory!) to consumers/firms via a decrease in mortgage rates/loans. This then has effects on the various components of AD/AS.
Interest Rates and the Impact of Interest Rate Change
The Monetary Policy Committee (MPC) sets the 'bank rate' of interest for the economy. This interest rate is used by banks as a guide for their interest rates when lending to individuals and businesses. If the bank rate falls it has many effects:
Housing market and consumption
- Mortgages become cheaper because the interest rate charged by banks falls. This allows first-time house buyers to take out more mortgages. The housing market booms.
- As the housing market booms, existing homeowners experience a positive wealth effect because houses go up in value. They may take out larger mortgages giving them more to spend now (equity withdrawal effect).
- Existing mortgage holders have lower monthly repayments so they may spend more elsewhere in economy.
Consumption
- Loans are cheaper. So people borrow more to finance consumption, especially consumer durables. AD rises, with ensuing positive multiplier effects.
- The return on savings falls when the interest rate falls, and the opportunity cost of consuming falls, so can spend more.
Government spending
- Lower corporate borrowing rates means that the government can borrow money at an even lower interest rate.
- The government can borrow more cheaply, so running a fiscal deficit (spending > tax revenue) is less negative (or important) than when interest rates are high.
- But in a booming economy, tax revenues may rise, making a fiscal budget deficit less likely.
Trade and exchange rates
- Lower interest rates means hot money (speculative money flows that chases the highest rate of return) flow out, which means there is an increase supply of sterling, and a fall in demand for sterling, causing the currency to depreciate.
- This means imports become more expensive in domestic currency terms, exports become cheaper in foreign currency terms; ceteris paribus demand for M falls and X rises , so value of X rises and M falls and the trade deficit falls, so AD rises.
Business investment
- Loans are cheaper now, so easier to meet hurdle rate of return projects. This means more projects are undertaken, e.g. construction, so real GDP rises.
- Previously unprofitable projects now become profitable.
Test yourself on Demand-Side Policies - Monetary
What is the main tool used by the MPC to control the rate of inflation?
What policy is most likely to result in the change shown (AD to AD1)?
What policy is most likely to shift AD leftwards?
Which of the following are potential effects of lowering the base interest rate?
Which of the following is an effect of increased interest rates?