AQA A-level Economics: Central banks and monetary policy (7136) – Revision Notes

These revision notes condense central banks and monetary policy for AQA A-level Economics (7136), specification version 1.3. The content point is printed as 4.2.4.3 in the PDF and numbered 3.2.4.3 on the AQA website. The specification gives no AS-only or A-level-only label for it. For full explanations, read the study guide, then test yourself with the practice questions. Course pages: AQA A-level Economics hub, the checklist and the free diagnostics. Related: aggregate demand and supply. All figures are invented and illustrative.

Key definitions

Term	Meaning
Central bank	The state’s bank and the banks’ bank; the Bank of England in the UK
Monetary policy	Central bank action on interest rates, money supply and credit, and the exchange rate
Bank rate	The rate paid on commercial banks’ reserves at the central bank; anchors market rates
MPC	The Monetary Policy Committee, which votes on bank rate
Inflation target	A government-set goal of 2% for CPI inflation
Transmission mechanism	The chain from a change in bank rate to AD, output and inflation
Real interest rate	Nominal rate adjusted for inflation
Appreciation	A rise in the value of the currency against others
Quantitative easing	Creating electronic reserves to buy assets, mainly gilts
Funding for Lending	Cheap bank funding tied to lending to households and firms
Forward guidance	Signals about the likely future path of policy

Functions of a central bank

1. Issue banknotes.
2. Banker to the government.
3. Banker to commercial banks, who hold reserve accounts there.
4. Lender of last resort.
5. Carry out monetary policy.
6. Contribute to financial stability (regulation is a separate topic).

Objectives and the MPC

• The government sets the objectives. The Bank chooses how to meet them.
• Central objective: price stability, with a 2% CPI target.
• Subject to that, support growth and employment.
• The MPC has nine members and decides by majority vote.
• If inflation is more than one percentage point from target, the Governor writes an open letter to the Chancellor.

Method: judging the likely decision

1. Calculate inflation from the index: (new - old) / old x 100.
2. Compare it, and the forecast, with 2%.
3. Check the output gap, wages and unemployment.
4. Check the exchange rate, import prices and global conditions.
5. State the decision, and why, using the data given.

Reminder. CPI moves from 104.0 to 105.6: (105.6 - 104.0) / 104.0 x 100 = 1.5%. That is below the target by 0.5 percentage points. With weak demand, a cut is more likely than a rise.

Factors the MPC considers

Factor	Points to a rise in bank rate when	Points to a cut when
Forecast inflation	Above 2%	Below 2%
Output gap	Positive, little spare capacity	Negative, large spare capacity
Wage growth	Strong, outpacing productivity	Weak
Unemployment	Very low	Rising
Exchange rate	Falling, raising import prices	Rising, cutting import prices
Credit and house prices	Rapid growth	Falling
World economy	Strong, with rising commodity prices	Weak
Confidence and expectations	Expectations of higher inflation	Falling confidence

Transmission mechanism: a rise in bank rate

• Market rates rise, and saving becomes more attractive.
• Consumption falls: dearer credit, higher saving, lower disposable income for variable-rate borrowers, lower asset prices.
• Investment falls: higher cost, fewer viable projects.
• Currency rises: financial inflows seek higher returns.
• Net exports fall: exports dearer, imports cheaper.
• AD falls, so demand-pull inflation eases and import costs fall.
• Cost to remember: lower output, higher unemployment and a worse current account may follow.
• A cut works in reverse. Lags of a year or more are common.

Reminder: real rate. A nominal rate of 4% with inflation of 1.5%: approximate real rate 4 - 1.5 = 2.5%. Exact: (1.04 / 1.015) - 1 = 2.46%.

Reminder: household cost. A variable-rate, interest-only mortgage of £80,000 moves from 2.5% to 3.0%. Interest rises from £2,000 to £2,400 a year, so £400 a year more.

Exchange rate effects

	Appreciation	Depreciation
Export prices abroad	Rise	Fall
Import prices at home	Fall	Rise
Net exports and AD	Fall	Rise
Inflation	Eases	Rises
Growth and jobs	Lower	Higher
Current account	Tends to worsen	Tends to improve

The effect on the current account depends on how elastic trade volumes are, and timing.

Reminder: exchange rate arithmetic. £1 = €1.20 falls to £1 = €1.10. A £25 export goes from €30.00 to €27.50, a fall of 8.3%. A €60 import goes from £50.00 to £54.55, a rise of 9.1%.

Money supply and recent instruments

Instrument	How it works	Intended effect	Limits
Bank rate	Moves market interest rates	Changes borrowing, saving, exchange rate	Lags; cannot fall far below zero
Quantitative easing	Bank buys gilts with new reserves; sellers gain deposits	Lower long-term yields, more broad money, higher asset prices	Banks may hoard reserves; benefits asset owners
Funding for Lending	Cheap funding linked to net lending	Cheaper, more available credit	Only works if firms and households want to borrow
Forward guidance	Communicates future path	Shapes expectations now	Needs credibility

Reminder: QE accounting. The Bank buys £30bn of gilts from a pension fund: pension fund deposits +£30bn; commercial bank reserves +£30bn.

Worked reminder: size of an AD change

Country A has GDP of £960bn. A rise in bank rate cuts consumption by £6bn, investment by £4bn and net exports by £2bn. The initial fall is 6 + 4 + 2 = £12bn. With a multiplier of 1.6, the final fall in GDP is 12 x 1.6 = £19.2bn, which is 19.2 / 960 x 100 = 2.0% of GDP. In the AD/AS diagram, the AD curve shifts left, the price level falls relative to where it would have been, and real output falls along the SRAS curve.

Essay chain for an extended question

1. Define monetary policy and name the objective (2% inflation).
2. Explain how the MPC uses bank rate, with the transmission chain.
3. Apply the context: which data suggest a rise or a cut, and why.
4. Add the exchange rate channel and its effect on AD and the other objectives.
5. Add unconventional tools if bank rate is already very low: QE, Funding for Lending, forward guidance.
6. Evaluate: lags, type of inflation, effects on different groups, global factors, size of the effect.
7. Give a judgement that depends on the context, such as demand-pull against cost-push inflation, and say why.

Must-know distinctions

• Nominal rate against real rate.
• Bank rate (set by the MPC) against market rates (set by banks).
• Government sets the target; the MPC pursues it.
• QE against printing banknotes: QE buys assets with electronic reserves.
• Demand-pull against cost-push inflation: monetary policy is better against the first.
• Appreciation against depreciation, and its effect on each objective.

Evaluation points

• Lags and forecast errors.
• Cost-push inflation: raising rates may cut output without fixing the cause.
• Low rates: little room to cut, and weak confidence.
• Unequal effects on savers, borrowers and exporters.
• Global factors and other countries’ policies.
• Policy can conflict: stopping inflation can raise unemployment.

Quick self-test

1. Name four functions of a central bank.
2. Who sets the inflation target?
3. CPI rises from 104.0 to 105.6. Find inflation.
4. A nominal rate is 6% and inflation is 4%. Find the approximate real rate.
5. Why might a higher bank rate raise the exchange rate?
6. Give two ways higher interest rates reduce consumption.
7. A mortgage of £80,000 moves from 2.5% to 3.0%, interest only. Find the annual increase.
8. State one effect of an appreciation on inflation.
9. Under QE, what does the Bank use to buy gilts?
10. What does forward guidance try to influence?

Answers

1. Issue notes, banker to government, banker to banks, lender of last resort, carry out monetary policy (any four).
2. The government.
3. 1.5%.
4. 2%.
5. Higher returns attract foreign financial inflows, raising demand for the currency.
6. Dearer borrowing and more attractive saving; less disposable income for variable-rate borrowers; lower asset values (any two).
7. £400.
8. Imports become cheaper, so costs and inflation ease.
9. Newly created electronic reserves.
10. Expectations of future interest rates, and so current spending and borrowing.

Where marks are usually lost

• Writing “interest rates fall” without stating which rate, or without the link to AD.
• Saying the MPC sets the target, rather than the government.
• Describing QE as printing banknotes.
• Skipping the lag, so the answer sounds instant.
• Leaving out whether the exchange rate channel strengthens or weakens the other channels.
• Applying a rate rise to cost-push inflation without noting the limits.
• Evaluating with a generic “it depends” instead of naming what it depends on.
• Using real-world figures from memory rather than the data in the question.

Official syllabus

AQA AS and A-level Economics specification (7135 and 7136), version 1.3, for first teaching from September 2015; published by AQA. Section 4.2.4.3 in the PDF, numbered 3.2.4.3 on the AQA website.