IB DP Economics: Monetary policy

This guide covers monetary policy, sub-topic 3.5 of Unit 3 (Macroeconomics). It follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. Most of 3.5 is for both SL and HL. Money creation by commercial banks, the tools of monetary policy and the money market diagram are HL only and are marked that way below.

All figures in the examples belong to Tavoria, an invented country with an invented currency, the tav. They are illustrative and not real data. When you have read this, use the revision notes to consolidate and the practice set to test yourself. The course page is IB DP Economics and the printable checklist lets you tick off each point.

What 3.5 asks you to do

Content	Skill required	Level
Monetary policy	Explain control of the money supply and interest rates by the central bank	SL and HL
Goals	Link policy to stable inflation (including inflation targeting), low unemployment, smoother cycles, a stable climate for long-term growth, external balance	SL and HL
Money creation by commercial banks	Explain how banks create money from deposits	HL only
Tools	Open market operations, minimum reserve requirements, the central bank’s minimum lending rate, quantitative easing	HL only
Money market	Show how the demand for and supply of money set the equilibrium interest rate (diagram)	HL only
Real and nominal rates	Calculate real interest rates from given data	SL and HL
Policy direction	Draw AD/AS diagrams for easing and tightening aimed at recessionary and inflationary gaps	SL and HL
Effectiveness	Evaluate constraints, strengths, and the record on growth, unemployment and inflation	SL and HL

The guide sets the recessionary and inflationary gap diagrams and the effectiveness material at the evaluation level (AO3), so a description is never enough. The rest is application and analysis (AO2), and calculations are skills (AO4).

The idea behind the policy

Monetary policy means the central bank steering the economy through the money supply and interest rates. It is a demand-side policy: it works by changing aggregate demand (AD), made up of consumption, investment, government spending and net exports. It is usually carried out by the central bank.

The goals

• Low and stable inflation. Many central banks follow inflation targeting: the government or the bank announces a numerical target, for instance 2%, and interest rates are moved to steer inflation towards it. A published target helps firms and workers form expectations.
• Low unemployment. Higher AD raises demand for labour, so cyclical unemployment falls.
• Reducing business cycle fluctuations. Rates are cut in a downturn and raised in a boom, aiming for a smoother path of output.
• A stable economic environment for long-term growth. Predictable prices and borrowing costs support investment.
• External balance. Interest rates affect the exchange rate and the demand for exports and imports, so the current account is part of the picture.

Goals can conflict. Cutting rates to cut unemployment may push inflation above its target. State which goal is being traded for which.

Real and nominal interest rates

The nominal interest rate is the rate quoted, with no adjustment for inflation. The real interest rate takes inflation into account:

real interest rate ≈ nominal interest rate − inflation rate

Worked example. A Tavorian savings account pays 6.0% and inflation is 2.5%.

real rate = 6.0% - 2.5% = 3.5%

Savers gain 3.5% purchasing power a year. If the account paid 2.0% and inflation was 3.5%, the real rate would be 2.0% - 3.5% = -1.5%: savings lose purchasing power. Borrowers gain when real rates are negative. The real rate matters more than the nominal rate for decisions to save, borrow and invest.

Expansionary and contractionary policy

Transmission

When the central bank cuts its policy rate, commercial banks’ lending and deposit rates tend to fall.

1. Borrowing is cheaper, so households take more loans for cars and homes.
2. Existing borrowers pay less interest, which leaves more income to spend. A household with a 150,000 tav variable-rate loan whose rate falls from 4% to 3% pays 6,000 - 4,500 = 1,500 tavs a year less.
3. Saving is less rewarding, so consumption is more attractive.
4. Investment projects with a lower expected return become worthwhile. A project expected to return 4.5% is rejected with borrowing at 5.0% but accepted at 3.5%.
5. A lower rate can reduce the demand for the currency, so the exchange rate may fall and net exports rise.

Consumption (C), investment (I) and net exports (X - M) rise, so AD shifts right. A rate rise works in the reverse direction.

Closing a recessionary (deflationary) gap

Take a recession in Tavoria: potential output is 800 bn tavs, actual real GDP is 740 bn tavs. The gap is 740 - 800 = -60 bn, or -7.5% of potential.

Item	Setting
Vertical axis	Price level
Horizontal axis	Real GDP (bn tavs)
Full-employment output	Vertical LRAS at 800
Starting point E1	AD1 crosses AS at real GDP 740
After the policy E2	AD2 crosses AS at real GDP 800

In words: the economy starts at E1 where AD1 meets AS, with real GDP of 740 bn, below full employment. Expansionary monetary policy (lower interest rates, a bigger money supply) shifts AD right from AD1 to AD2. The new equilibrium E2 is at 800 bn, so output rises, unemployment falls and the price level rises a little. Label the axes (price level, real GDP), both AD curves, AS or LRAS, the gap and full-employment output.

Closing an inflationary gap

Now potential output is 1,000 bn tavs and actual output is 1,060 bn: a positive gap of 60 bn, 6% of potential. Demand is pulling prices up. Contractionary policy raises interest rates, which reduces C and I and may raise the exchange rate. AD shifts left from AD1 to AD2, real GDP falls back to 1,000 bn, and the price level stops rising (or falls relative to where it would have been). The cost is lower output growth and possibly higher unemployment in the short run.

If your course teaches both Keynesian and monetarist or new classical AS, draw the version your teacher uses, and say what changes: with a vertical long-run AS the effect of a demand shift on output is only temporary.

HL only: how commercial banks create money

Banks keep only a fraction of deposits as reserves and lend out the rest. Each loan becomes a new deposit somewhere in the banking system, and the process repeats.

Suppose the minimum reserve requirement is 20% and a customer deposits 1,000 tavs.

Round	New deposit	Reserve kept (20%)	Lent out
1	1,000	200	800
2	800	160	640
3	640	128	512
and so on	…	…	…

The deposits shrink by a factor of 0.8 each round. The maximum total of deposits is the original deposit multiplied by 1/(reserve ratio):

money multiplier = 1 / 0.20 = 5
total deposits   = 1,000 x 5 = 5,000 tavs
new money created = 5,000 - 1,000 = 4,000 tavs

This is the upper limit. It is smaller if banks hold more than the minimum, or if people hold cash instead of redepositing it. The key idea: the money supply is made up largely of bank deposits, so what banks lend matters as much as what the central bank prints.

HL only: tools of monetary policy

Tool	What the central bank does	Expansionary use	Contractionary use
Open market operations	Buys or sells government bonds in the market	Buy bonds: banks gain reserves, lending rises	Sell bonds: reserves fall
Minimum reserve requirement	Changes the required reserve ratio	Lower the ratio: multiplier rises	Raise the ratio: multiplier falls
Minimum lending rate (base, discount or refinancing rate)	Changes the rate it charges banks	Cut it: market rates tend to fall	Raise it: market rates tend to rise
Quantitative easing	Creates reserves electronically to buy large amounts of assets	Used when rates are already very low	Reversed by selling assets

Cutting the reserve ratio from 10% to 8% raises the multiplier from 10 to 12.5. On a 400 tav initial deposit the maximum deposits rise from 4,000 to 5,000.

HL only: the money market and the equilibrium interest rate

The demand for money slopes downward: a high interest rate is a high opportunity cost of holding cash, so people hold less. The supply of money is vertical, since the central bank sets it. Axes: interest rate (vertical), quantity of money (horizontal). Equilibrium is where they cross.

Suppose Tavoria’s money demand is Md = 500 - 40r (r in %, Md in bn tavs) and supply is 300 bn.

500 - 40r = 300
r = 200/40 = 5%

If the central bank buys bonds or uses quantitative easing and the supply becomes 340 bn:

500 - 40r = 340
r = 160/40 = 4%

The supply curve shifts right, the equilibrium rate falls from 5% to 4%, and cheaper borrowing raises AD. A fall in money supply to 260 bn raises r to 6%. A rise in incomes shifts demand for money right and raises the equilibrium rate unless supply changes.

Effectiveness of monetary policy

Constraints

• Limited scope when rates are close to zero. Rates cannot usefully go much below zero, so the central bank runs out of room in a deep recession.
• Low consumer and business confidence. If households fear for their jobs and firms see no demand, cheaper credit may not be used: “pushing on a string”.

Strengths

• Incremental, flexible and easily reversible. Rates can move in small steps and be reversed quickly if conditions change.
• Short time lags. Compared with some other policies, effects begin soon after a change, though the full effect takes time.

Growth, unemployment and inflation

Objective	Strength	Limitation
Inflation	A credible target anchors expectations; higher rates cool demand	Cost-push inflation from supply shocks is not cured by weaker demand without a loss of output
Unemployment	Lower rates raise AD and demand for labour	Does not tackle structural unemployment
Growth	Stable prices and low borrowing costs encourage investment	Affects demand, not the productive capacity of the economy

To evaluate, weigh these against each other, ask which gap is being closed, how deep the recession is, and how confident households are. Reach a judgement.

Common errors

• Writing real rate = nominal + inflation. It is nominal minus inflation.
• Drawing the money supply as upward sloping in the money market diagram.
• Shifting AS instead of AD when interest rates change.
• Stating that monetary policy is “fast” without noting that the full effect takes time.
• Describing the HL tools in an SL answer, which is not required.

Examination context

In the guide’s assessment outline, Paper 1 asks for extended responses (choose one of three), Paper 2 is data response with some quantitative questions, and the HL policy paper is Paper 3. HL-only content is examined only at HL. The command terms define the depth, so check whether you are asked to explain (reasons) or evaluate (strengths and limitations). Monetary policy is one of two demand-management policies; the other is covered in the fiscal policy guide. For general advice see the exam preparation page. Take a free 10-minute diagnostic when you are ready.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization, February 2020, sub-topic 3.5.