IB DP Economics: Monetary policy – Revision Notes

These notes condense sub-topic 3.5 (Demand management: monetary policy) of Unit 3. They follow the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. Money creation, the tools of monetary policy and the money market diagram are HL only; everything else is SL and HL. For full explanations read the study guide, then test yourself with the practice set. The course page is IB DP Economics and the printable checklist tracks your progress. All data below is from Tavoria, an invented country, and is illustrative.

Core definitions

Term	Meaning
Monetary policy	Control of the money supply and interest rates by the central bank to influence aggregate demand
Inflation targeting	A published numerical inflation goal, with interest rates adjusted to meet it
Nominal interest rate	The rate quoted, not adjusted for inflation
Real interest rate	Nominal rate adjusted for inflation: nominal - inflation
Expansionary policy	Lower rates or a larger money supply: AD shifts right
Contractionary policy	Higher rates or a smaller money supply: AD shifts left
Recessionary (deflationary) gap	Actual real GDP below potential output
Inflationary gap	Actual real GDP above potential output
Minimum reserve requirement (HL only)	The fraction of deposits banks must hold as reserves
Quantitative easing (HL only)	Electronic creation of reserves to buy assets in bulk

Goals of monetary policy: recall list

1. Low and stable inflation, including inflation targeting.
2. Low unemployment.
3. Reducing business cycle fluctuations.
4. A stable environment for long-term growth.
5. External balance.

Potential conflict: pursuing goal 2 by cutting rates can threaten goal 1.

Formulas and calculations

Item	Formula	Example
Real interest rate	nominal rate - inflation rate	5.5% - 2.0% = 3.5%
Inflation from an index	(new index - old index) / old index x 100	(128.5 - 125.0) / 125.0 x 100 = 2.8%
Output gap (% of potential)	(actual - potential) / potential x 100	(1,140 - 1,200) / 1,200 x 100 = -5%
Money multiplier (HL only)	1 / reserve ratio	1 / 0.125 = 8
Maximum deposits (HL only)	initial deposit x multiplier	500 x 10 = 5,000 at a 10% ratio
New money (HL only)	maximum deposits - initial deposit	5,000 - 500 = 4,500

Method: real interest rate

1. Write down the nominal rate.
2. Write down the inflation rate over the same period.
3. Subtract.
4. State whether the result is positive or negative, and what that means for savers and borrowers.

A saver earning 2.0% when inflation is 3.5% has a real return of 2.0% - 3.5% = -1.5%.

Transmission: expansionary chain

Rate cut → cheaper borrowing and a smaller reward for saving → C and I rise → possibly a lower exchange rate, so X - M rises → AD shifts right → real GDP rises, unemployment falls, the price level rises.

Contractionary chain: the reverse.

Small worked reminder: a 150,000 tav loan at 4% costs 6,000 a year in interest; at 3% it costs 4,500, saving 1,500. Investment rule: go ahead if the expected return exceeds the borrowing rate, so a 4.5% project fails at 5.0% and passes at 3.5%.

Diagram checklists

Expansionary policy (recessionary gap)

• Axes: price level (vertical), real GDP (horizontal).
• Draw AS and AD1 meeting at a real GDP below potential.
• Mark potential output (LRAS or full employment).
• Draw AD2 to the right, reaching potential.
• Label the old and new equilibria and the gap, and write what changed.

Contractionary policy (inflationary gap)

• Same axes. AD1 crosses AS above potential output.
• Draw AD2 to the left, back to potential.
• Label the equilibria and the gap.

Money market (HL only)

• Axes: nominal interest rate (vertical), quantity of money (horizontal).
• Downward-sloping demand for money, vertical supply of money.
• Equilibrium where they cross. A rise in supply moves the vertical line right and the rate down.

HL only: tools at a glance

Tool	Expansionary	Contractionary
Open market operations	Buy bonds	Sell bonds
Minimum reserve requirement	Lower	Raise
Central bank minimum lending rate	Cut	Raise
Quantitative easing	Create reserves to buy assets	Stop, or sell the assets

Method: money creation (HL only)

1. Find the reserve ratio as a decimal.
2. Multiplier = 1 / ratio.
3. Maximum total deposits = initial deposit x multiplier.
4. New money created = total deposits - initial deposit.
5. Say it is a maximum: banks holding extra reserves or customers holding cash lower it.

Worked reminder: a deposit of 800 with a ratio of 12.5% gives a multiplier of 8, total deposits 6,400 and new money 5,600.

Method: money market numbers (HL only)

With Md = 500 - 40r and a money supply of 300: 500 - 40r = 300, so r = 5%. If supply becomes 340: r = 4%. If it becomes 260: r = 6%.

Effectiveness: evaluation grid

Point	For	Against
Flexibility	Incremental, flexible, easily reversible	Fine-tuning needs good forecasts
Speed	Short time lags	The full effect still takes time
Low rates	Cheap credit supports spending	Little room to cut when rates are near zero
Confidence	Cheaper credit encourages spending if people are optimistic	Low consumer and business confidence blunts the effect
Inflation	Credible target anchors expectations	Weak against cost-push inflation without losing output
Unemployment	Lower rates raise AD	Does not solve structural unemployment
Growth	Stability helps long-term investment	Acts on demand, not on productive capacity

For a good evaluation: make a point, support it with a reason, give a counter-point, then judge which matters more in the case given.

Must-know distinctions

• Nominal vs real rate. Nominal ignores inflation; real subtracts it.
• Expansionary vs contractionary. AD right vs AD left.
• Recessionary vs inflationary gap. Output below potential vs above.
• Money supply vs money demand (HL only). The central bank sets supply; interest rates (the opportunity cost of holding cash) influence demand.
• Demand-side vs supply-side. Monetary policy shifts AD; it does not directly change the productive capacity of the economy.

Command terms for this topic

Command term	What the guide’s glossary asks for
Define	The precise meaning of a term
Outline	A brief account
Calculate	A numerical answer with the working shown
Explain	A detailed account including reasons or causes
Evaluate	A judgement from weighing strengths and limitations
Discuss	A balanced review of several arguments, with a clear conclusion

The guide places the gap diagrams and the effectiveness points at the evaluation level. The guide lists extended responses for Paper 1, data response with some calculation for Paper 2, and a policy paper (Paper 3) at HL. Use a calculation, a labelled diagram and a judgement wherever the question allows.

Quick self-test

1. Define monetary policy.
2. State two goals of monetary policy.
3. Nominal rate 7.0%, inflation 3.0%. Find the real rate.
4. Nominal rate 1.5%, inflation 2.5%. Find the real rate.
5. Which direction does AD move when the central bank raises rates?
6. A price index rises from 125.0 to 128.5. Find the inflation rate.
7. Give one reason why cutting rates may not raise spending in a deep recession.
8. State one strength of monetary policy listed in the guide.
9. (HL only) A reserve ratio is 20%. Find the money multiplier.
10. (HL only) A deposit of 500 and a ratio of 10%. Find the maximum new money created.
11. (HL only) With Md = 500 - 40r and a supply of 340, find r.
12. (HL only) Is open market selling of bonds expansionary or contractionary?

Answers

1. Control of the money supply and interest rates by the central bank to influence the economy.
2. Any two of: low and stable inflation, low unemployment, reduced business cycle fluctuations, a stable environment for long-term growth, external balance.
3. 7.0% - 3.0% = 4.0%.
4. 1.5% - 2.5% = -1.0%.
5. Left (contractionary), because C and I fall.
6. (128.5 - 125.0) / 125.0 x 100 = 2.8%.
7. Low consumer or business confidence: households and firms may not borrow even when credit is cheap. Rates may also already be close to zero.
8. Incremental, flexible and easily reversible; or short time lags.
9. 1 / 0.20 = 5.
10. Multiplier 10, so total deposits 5,000, new money 5,000 - 500 = 4,500.
11. 500 - 40r = 340, so 40r = 160 and r = 4%.
12. Contractionary: it removes reserves from banks.

Where marks are usually lost

• Adding inflation to the nominal rate instead of subtracting it.
• Leaving out the units or the sign: -1.5% is not 1.5%.
• Unlabelled diagrams: no axes, no equilibrium, no gap marked.
• Shifting AS when the policy is a change in interest rates.
• Describing the transmission chain with no link to AD at the end.
• One-sided answers to evaluation questions, with no counter-argument or judgement.
• Mixing up the money market diagram with the AD/AS diagram (the vertical axis is the interest rate there).
• Giving HL tools to an SL-only question without linking them to the question set.
• Writing “the central bank prints money” and stopping, with no effect on interest rates or lending.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization, February 2020, sub-topic 3.5. See also the exam preparation page and the free 10-minute diagnostics.