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

This guide covers central banks and monetary policy for AQA A-level Economics (7136), using the AQA AS and A-level Economics specification, version 1.3. It teaches the content point headed “Central banks and monetary policy” in the national and international economy section. The specification PDF prints it as 4.2.4.3; the AQA website and our site map number it 3.2.4.3. The specification does not mark any of this as AS-only or A-level-only in that section. All figures below are invented and illustrative, set in “Country A”.

Commercial banks, credit creation and regulation have their own pages, and so do bonds and financial markets. Here we stay with the central bank and its policy tools.

Companion pages: revision notes and practice questions. For the aggregate demand and supply framework, see aggregate demand and supply. Course pages: AQA A-level Economics hub and the printable checklist. To find weak spots first, try the free diagnostics.

What the specification asks for

Content point	What the specification expects
Main functions of a central bank	List and explain them
Monetary policy	Explain it as action on interest rates, money supply and credit, and the exchange rate
Current objectives set by government	State and apply them, including the inflation target
The MPC and bank rate	Explain how bank rate changes aim at the objectives
Factors the MPC considers	Use data to justify a rate decision
Exchange rate and AD	Explain effects on AD and on each macroeconomic objective
Transmission mechanism	Trace the chain, including interest rates and the exchange rate
Money supply	Explain how the Bank of England can influence its growth
Recent instruments	Quantitative easing, Funding for Lending, forward guidance

Functions of a central bank

A central bank is the state’s bank and the banking system’s bank. The main functions are:

• Issuing banknotes and keeping the currency trusted.
• Acting as banker to the government, keeping its main accounts and making its payments.
• Acting as banker to commercial banks, which hold reserve accounts with it and settle payments between themselves there.
• Acting as lender of last resort, lending to a sound bank that cannot find funds elsewhere, so that a shortage of cash does not become a collapse.
• Carrying out monetary policy for the government.
• Contributing to financial stability. The detail of regulation belongs to a separate topic.

Monetary policy and its objectives

Monetary policy is action by the central bank to influence three things: interest rates, the supply of money and credit, and the exchange rate. In the UK the government sets the objectives and the Bank of England decides how to meet them. The central objective is price stability, defined as a target of 2% for CPI inflation. Subject to that, the Bank supports the government’s wider aims, such as growth and employment. The Chancellor can restate the remit each year.

Monetary policy is a demand-side policy. Its main effect is to shift aggregate demand, which is why you analyse it with AD/AS diagrams.

The MPC and bank rate

Bank rate is the rate the Bank pays on money that commercial banks keep in their accounts at the Bank. It anchors other interest rates in the economy. The Monetary Policy Committee (MPC) sets it. It has nine members, including the Governor and external members, and each votes. The outcome follows a majority.

Worked example: inflation against the target. Country A’s CPI index is 112.5 in year 1 and 116.1 in year 2.

inflation = (116.1 - 112.5) / 112.5 x 100 = 3.2%
gap to target = 3.2 - 2.0 = 1.2 percentage points above

Inflation of 3.2% is more than one percentage point above target. In the UK system the Governor must then write an open letter to the Chancellor explaining the gap and the planned response. With inflation above target and forecast to stay there, the MPC is likely to raise bank rate. If inflation were forecast below target, with weak demand, it would lower bank rate.

Factors the MPC considers

The MPC looks forward, because policy works with a delay. Key factors:

• Forecast inflation against the 2% target, and measures of inflation expectations.
• Growth, the output gap and spare capacity.
• The labour market: unemployment, wage growth and productivity.
• Consumer spending, confidence, house prices and credit growth.
• The exchange rate and import prices.
• Global conditions, including world growth and commodity or energy prices.
• Fiscal policy, because tax and spending changes move AD too.
• Risks to financial stability.

Exam use: say whether each factor points to higher or lower bank rate, and why. Rising wage growth with little spare capacity points to a rise. A falling exchange rate that lifts import prices also points to a rise.

The transmission mechanism

The transmission mechanism is the chain by which a change in bank rate reaches inflation and output. Take a rise in bank rate:

1. Banks raise rates on loans and mortgages, and savings rates rise too.
2. Consumption falls. Borrowing costs more, saving pays more, and households with variable-rate debt have less disposable income. Higher rates can also lower asset prices, which reduces wealth and confidence.
3. Investment falls. Borrowing is dearer, and fewer projects reach the required rate of return.
4. Higher rates attract foreign financial inflows. Demand for the currency rises, and so does the exchange rate.
5. A stronger currency makes exports dearer abroad and imports cheaper at home, so net exports fall.
6. AD falls. The fall in demand reduces demand-pull pressure, and cheaper imports reduce cost pressure, so inflation slows.

Lags matter. Many mortgages and business loans adjust slowly, and firms take time to cancel plans. The full effect can take a year or more, so decisions rest on forecasts.

Worked example: real interest rate. A saver earns 5% nominal while inflation is 3%.

approximate real rate = 5 - 3 = 2%
exact real rate = (1.05 / 1.03) - 1 = 1.94%

Households react to the real return, not only the headline rate. If inflation were 4.5% and savings paid 3%, the real return would be negative: (1.03 / 1.045) - 1 = -1.44%.

Worked example: a household. A household has a variable-rate, interest-only mortgage of £120,000.

at 3.5%: 120,000 x 0.035 = £4,200 a year
at 5.0%: 120,000 x 0.050 = £6,000 a year
increase = £1,800 a year = £150 a month

That £150 a month is spending power taken out of the circular flow. Multiplied over many households, it explains why consumption responds.

Worked example: size of the AD effect. In Country A, GDP is £960bn. A rise in bank rate cuts consumption by £6bn, investment by £4bn and net exports by £2bn.

initial fall in AD = 6 + 4 + 2 = £12bn
with a multiplier of 1.6: 12 x 1.6 = £19.2bn
as % of GDP: 19.2 / 960 x 100 = 2.0%

Exchange rates, AD and the objectives

An exchange rate can move for many reasons, but for monetary policy the link is direct: higher relative interest rates tend to raise the currency, and lower relative rates tend to lower it.

Worked example: appreciation. The pound rises from 1.30 dollars to 1.50 dollars.

UK export priced at £40: 52 dollars before, 60 dollars after (+15.4% in dollars)
US import priced at 90 dollars: £69.23 before, £60.00 after (-13.3% in pounds)

Effects of appreciation:

• AD: exports fall and imports rise, so net exports and AD fall, subject to elasticities.
• Inflation: cheaper imports of final goods and raw materials lower costs and prices.
• Growth and employment: lower AD slows growth, and export and import-competing industries may cut jobs.
• Current account: the balance tends to worsen, although this depends on elasticities and timing.

A depreciation has the opposite effects, with higher import prices and a boost to export demand. Both effects depend on how elastic trade volumes are.

Influencing the money supply

The Bank can influence the growth of money and credit by changing bank rate, which affects the demand for loans. In recent decades it also used less conventional instruments.

Quantitative easing (QE). The Bank creates new reserves electronically and uses them to buy assets, mainly government bonds (gilts) from institutions such as pension funds. QE began in the UK in 2009. Buying bonds pushes up their price and lowers their yield, and so lowers longer-term borrowing costs. The sellers receive deposits, so broad money rises.

Bank buys £30bn of gilts from a pension fund
Pension fund: gilts -£30bn, bank deposit +£30bn
Commercial bank: deposit liability +£30bn, reserves at the Bank +£30bn

QE aims to raise spending, asset prices and inflation when bank rate is already very low. The sellers might also buy other assets, so asset prices rise, which can widen wealth inequality. Banks may hold the extra reserves rather than lend.

Funding for Lending. This scheme, launched in 2012, gave banks cheap funding linked to how much they lent to households and firms. It aimed to lower lending rates and lift the supply of credit.

Forward guidance. The central bank signals the likely future path of policy. If people expect low rates to last, long-term rates and spending decisions adjust now. It works only if the message is credible and consistent.

Evaluating monetary policy

• Time lags make forecasting errors likely.
• Cost-push inflation from energy or import prices comes from the supply side. Raising bank rate then risks lowering output without removing the cause.
• Near zero, bank rate cannot fall much further, and confidence may be so low that cheap credit is not used.
• Effects differ between groups: borrowers, savers, exporters and those on fixed-rate debts.
• Global factors, such as other central banks’ decisions, can swamp domestic policy.
• Independence helps credibility, although the objective is set by government.

Common errors

• Saying the MPC sets the inflation target. The government sets it.
• Describing QE as printing banknotes. It is the creation of electronic reserves to buy assets.
• Stopping the chain at “interest rates rise”. Complete it to AD and inflation.
• Treating an appreciation as always good. It helps with inflation and hurts export industries.
• Ignoring the lag, and using only the headline rate when the real rate is what matters.

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.