Cambridge O Level Economics: Monetary policy (2281) – Revision Notes

These notes shorten Monetary policy, sections 4.4.1 to 4.4.3, from the Cambridge O Level Economics 2281 syllabus for examination in 2026 (topic 4, Government and the macroeconomy). The syllabus is not tiered. Full explanations and more worked examples are in the study guide; test yourself with the practice set. Use the course hub, the printable checklist and the free diagnostics to plan the rest of your revision. All figures here are made up.

4.4.1 Definitions to learn

• Money supply: the stock of money in a country at a given moment: notes, coins and bank deposits.
• Monetary policy: government action, usually through the central bank, on borrowing costs, the quantity of money and the currency’s value, to steer the economy towards its aims.

Monetary policy uses money and credit. Fiscal policy uses tax and government spending. Never mix them.

4.4.2 The three measures

Measure	Tight (slows spending)	Loose (raises spending)
Interest rate	Raise it	Cut it
Money supply	Reduce it or the credit banks can create	Increase it
Exchange rate	Allow or push the currency up	Allow or push the currency down

Interest rate chain (tight): dearer loans → less borrowing and spending by households and firms → saving more attractive → slower growth in total spending. Reverse for loose.

Ways to change the money supply: the central bank sells bonds (tight) or buys them (loose); raises or lowers the reserve requirement; limits or encourages lending.

Exchange rate:

Change	Exports	Imports
Appreciation	Dearer abroad	Cheaper at home
Depreciation	Cheaper abroad	Dearer at home

A higher interest rate tends to attract foreign savers, raising demand for the currency and its price.

Formulas and methods

Item	Method
Interest cost	Loan × rate
Percentage change	(New − old) ÷ old × 100
Real interest rate	Nominal rate − inflation rate (approximately)
Price of an export abroad	Home price × exchange rate (foreign units per home unit)
Price of an import at home	Foreign price ÷ exchange rate
Maximum deposits from a new deposit	New deposit ÷ reserve ratio

Method: exchange-rate arithmetic

1. Write the rate as foreign units per one home unit.
2. Multiply for exports; divide for imports.
3. Work out each percentage change from its own starting point. The changes are not equal in size.

Worked reminder. At 1 A-dollar = 0.50 B-dollars, an export priced at 1,000 A-dollars costs 500 B-dollars. If the rate rises to 0.60 it costs 600 (up 20%). A B-dollar import priced at 300 costs 600 A-dollars at 0.50 and 500 at 0.60 (down 16.7%). At 0.40 the import costs 750 (up 25%).

Worked reminder. A 5% saving rate with 3% inflation gives a real rate of about 2%. With 6% inflation it is about −1%.

Worked reminder. A loan of 200,000 at 6% costs 12,000 a year. At 9% it costs 18,000, which is a 50% rise in cost from a 3 point rise in the rate.

Worked reminder. Reserve ratio 10% and a new deposit of 1,000: maximum deposits 1,000 ÷ 0.10 = 10,000, so 9,000 of new lending. At 20%: 5,000 and 4,000.

4.4.3 Effects on the aims

Aim	Higher rates / stronger currency	Lower rates / weaker currency
Stable prices	Lower inflation	Higher inflation risk
Growth	Slower	Faster
Full employment	Unemployment may rise	Unemployment may fall
Balance of payments	Current account may worsen	Current account may improve
Redistribution	Savers gain, borrowers lose	Borrowers gain, savers lose

Chain for jobs: rate cut → cheaper borrowing → more investment and consumer spending → higher sales → more output → more workers hired.

Chain for inflation: rate rise → less spending → firms find it harder to raise prices → inflation slows.

Evaluation points (use two or three): low confidence; time lags; cost-push inflation (spending is not the cause); banks may not pass on changes; elasticity of demand for exports; imported inputs getting dearer when the currency falls; conflicts between aims.

Diagram in words: in the market for a currency, the exchange rate is on the vertical axis and the quantity of the currency on the horizontal axis. Higher demand for the currency shifts the demand curve right and raises the equilibrium rate.

Extra reminders

Money supply growth. If the money supply rises from 400 billion to 424 billion, growth is (424 − 400) ÷ 400 × 100 = 6%. If real output grows by only 2%, spending can grow faster than output, so prices may rise.

Who gains from a rate change.

Group	Rate rises	Rate falls
Borrower with a variable loan	Pays more	Pays less
Saver	Earns more	Earns less
Exporter	Hurt if the currency rises too	Helped if the currency falls
Importer	Helped if the currency rises	Hurt if the currency falls

Method: a discuss or evaluate answer in steps

1. State the measure and the aim it targets.
2. Give a chain of reasoning of at least three linked steps.
3. Give a limit: confidence, lags, cause of the problem, elasticity or a conflict.
4. Judge: say which effect is likely to be larger in the situation in the question, and why.

Worked reminder (invented). Country C has inflation of 9% and a large current account deficit. Its central bank lifts the rate from 5% to 8% and the currency appreciates. Spending falls and imports are cheaper, so inflation should slow. However, exports are dearer, so the deficit may not close, and slower growth may raise unemployment. If the inflation comes from higher import costs and not strong spending, the benefit is smaller.

Three conflicts to be ready for: full employment versus stable prices; growth versus balance of payments stability (faster growth sucks in imports); full employment versus balance of payments stability. Each can arise when one monetary measure helps one aim and harms another.

Must-know distinctions

Pair	Difference
Monetary vs fiscal	Money and credit, versus tax and spending
Nominal vs real rate	Quoted rate, versus rate after inflation
Appreciation vs depreciation	Currency worth more, versus worth less
Tight vs loose	Slows spending, versus raises it
Demand-pull vs cost-push	Spending too high, versus costs rising

Quick self-test

1. Define money supply.
2. Define monetary policy.
3. Name the three kinds of monetary policy measure.
4. Explain why a rise in the interest rate may reduce inflation.
5. A firm pays 4% on a loan of 150,000. The rate rises to 6%. Calculate the extra yearly interest.
6. Nominal rate 7%, inflation 4%. Estimate the real rate.
7. At 1 X-unit = 2 Y-units, an export costs 800 X-units. Find its price in Y-units.
8. The X-unit falls to 1 X-unit = 1.6 Y-units. Find the new price in Y-units and the percentage change.
9. Reserve ratio 20%, new deposit 500. Find the maximum total deposits.
10. State one effect of a cut in interest rates on borrowers and one on savers.
11. Give one reason a rate cut might fail to raise investment.
12. Explain one conflict between aims that a rate cut could create.

Answers

1. The stock of money in a country at a given moment.
2. Action on interest rates, the quantity of money and the exchange rate by the government or central bank, to move the economy towards its aims.
3. Interest rate changes, money supply changes and exchange rate changes.
4. Borrowing and spending fall and saving rises, so spending grows more slowly and firms find it harder to raise prices.
5. 150,000 × 0.06 − 150,000 × 0.04 = 9,000 − 6,000 = 3,000.
6. About 7 − 4 = 3%.
7. 800 × 2 = 1,600 Y-units.
8. 800 × 1.6 = 1,280 Y-units, a fall of (1,280 − 1,600) ÷ 1,600 × 100 = −20%.
9. 500 ÷ 0.20 = 2,500.
10. Borrowers pay less interest; savers earn less.
11. Low business confidence, so firms expect weak sales and do not borrow; or banks do not lend.
12. Lower rates raise spending and may cut unemployment but raise inflation (full employment versus stable prices), or may weaken the currency and raise import prices.

Where marks are usually lost

• Defining monetary policy as tax and spending changes.
• Giving the effect of a measure with no chain of steps between cause and result.
• Reversing the direction: a currency that appreciates makes exports dearer, not cheaper.
• Dividing when you should multiply (or the reverse) in exchange-rate questions, and quoting the same percentage for both directions.
• Treating the interest rate in the question as the real rate.
• Listing evaluation points without saying why they weaken the policy in this case.
• Forgetting redistribution: savers and borrowers are affected in opposite ways.
• Concluding without a judgement when the command word asks you to discuss or evaluate.

Official syllabus

Cambridge O Level Economics 2281, syllabus for examination in 2026, published by Cambridge University Press & Assessment (Cambridge Assessment International Education): section 4.4, Monetary policy.