OCR A Level Economics: Monetary policy and inflation targeting (H460) – Revision Notes

Condensed recall for the OCR A Level Economics (H460) Monetary policy topic (specification Version 3.0, June 2026, for first assessment in 2021, Macroeconomics content). For full explanations use the study guide, then test yourself with the practice questions. Related pages: OCR Economics hub, checklist and free diagnostics. All numbers are invented and illustrative.

Definitions

Term	Meaning
Monetary policy	Use of interest rates, the money supply, quantitative easing and the exchange rate to influence AD and meet macro objectives
Policy rate	The rate set by the central bank, which commercial rates follow
Money supply	The quantity of money and credit in the economy
Quantitative easing (QE)	The central bank creates electronic money to buy assets, usually government bonds, from financial institutions
Liquidity trap	Rates so low that further cuts fail to raise spending, as people hold cash
Inflation rate targeting	A published numerical inflation target that guides policy
Symmetric target	Misses above and below count equally
Asymmetric target	One direction of miss counts as worse, for example a ceiling
Real interest rate	Nominal rate adjusted for inflation

Formulas

Quantity	Formula
Inflation rate	change in index ÷ old index × 100
Real interest rate (approx.)	nominal rate − inflation rate
Real interest rate (exact)	(1 + nominal rate) ÷ (1 + inflation rate) − 1
Bond yield	coupon/price × 100
Percentage change in exchange rate	(new − old)/old × 100
Foreign price of an export	home price × units of foreign currency per home unit
Home price of an import	foreign price ÷ units of foreign currency per home unit
Multiplier	1/marginal propensity to withdraw
Final change in output	initial change in AD × multiplier

Quick worked reminders

Inflation. An index rises from 108.0 to 110.7. Inflation = 2.7/108.0 × 100 = 2.5%.

Real rate. Nominal 3.5% and inflation 2.0%. Approximate real rate = 1.5%. Exact = 1.035/1.02 − 1 = 1.47%.

Bond yield. A coupon of 4 on a bond priced at 100 gives 4.00%. After QE the price is 110, so the yield is 4/110 = 3.64%. Higher price means lower yield.

Exchange rate. The mu falls from 1.50 to 1.35 foreign units (fu). Change = −0.15/1.50 = −10%. An export priced at 80 mu costs 120 fu before and 108 fu after, so it is cheaper abroad. An import costing 60 fu costs 40 mu before and 60/1.35 = 44.44 mu after, up 11.1%.

Multiplier. A rate cut adds 1.5 billion mu to AD. With a marginal propensity to withdraw of 0.5, the multiplier is 2, so output rises by 3.0 billion mu.

The instruments in one table

Instrument	Direct effect	Effect on AD	Main risk
Higher interest rate	Dearer borrowing, better saving returns	C and I fall, exchange rate rises so net exports fall	Slower growth, higher unemployment
Lower interest rate	Cheaper borrowing	C and I rise, net exports rise	Demand-pull inflation, asset bubbles
Tighter money supply	Less credit	AD falls	Credit shortage for sound firms
QE	Lower bond yields, more money	C, I and wealth rise	Asset price inflation, unequal gains
Lower exchange rate	Cheaper exports, dearer imports	Net exports rise	Imported inflation
Higher exchange rate	Dearer exports, cheaper imports	Net exports fall	Loss of competitiveness

Method in steps: a transmission chain

1. State the change in the instrument.
2. Say which component of AD it affects: C, I or net exports.
3. Show the initial shift of AD, then add the multiplier.
4. State the effect on real output, employment and the price level using AD/AS.
5. Add a second-round effect, for example on the exchange rate or house prices.
6. Evaluate size and timing.

Liquidity trap checklist

• Interest rates are close to zero.
• The demand for money is very elastic, so people hold cash.
• Banks and borrowers do not respond to a further cut.
• Deflation expectations keep real rates high.
• Alternatives are QE, forward guidance and fiscal policy. Fiscal policy is covered in other units.

Targeting: symmetric versus asymmetric

Feature	Symmetric	Asymmetric
Concern	Both too high and too low	Mainly one direction
Deflation risk	Taken seriously	May be tolerated
Example	2% point target treated equally	A ceiling of 2%
Policy bias	Neutral	Towards tighter policy if the ceiling is the limit

The UK target is a CPI target of 2%, and the Bank of England has described it as symmetric.

Credible targets anchor expectations. Workers claim less, firms plan investment with confidence, lenders accept lower long-term rates, and the bank needs smaller rate moves.

Evaluation toolkit

Point	Why it limits or strengthens monetary policy
Time lags	Effects take a year or more, so policy can be mistimed
Cost-push	Higher rates do not directly lower input costs; a stronger currency helps only partly
Liquidity trap	Cuts cannot go below the floor
Household debt	Raises the impact of rate rises, lowers the impact of cuts if confidence is low
Savers and borrowers	Gains and losses differ across groups
Exchange rate	Exporters lose when it rises
Independence	Reduces political pressure, but needs accountability
Flexibility	Can be changed quickly, unlike most fiscal measures
Global factors	Open economies face foreign shocks that domestic rates do not affect
Judgement	Depends on cause of inflation, level of rates, credibility and spare capacity

How a central bank works to achieve its aims

1. Gather data and forecast inflation and output.
2. Compare the forecast with the target.
3. A committee votes on the policy rate.
4. Announce and explain the decision.
5. Use market operations to bring market rates into line, or QE if rates are at the floor.
6. Review outcomes and account for misses.

Quick self-test

1. Inflation is 2.5% against a symmetric target of 2%. State the gap.
2. Calculate the real interest rate (approximate) for 4.0% nominal and 2.5% inflation.
3. A bond with a coupon of 6 is priced at 120. Calculate the yield.
4. The mu moves from 2.00 to 2.50 fu. Calculate the percentage change.
5. A home product priced at 40 mu is sold abroad at that rate before the change in question 4. State the foreign price before and after.
6. An initial AD rise of 2 billion and a marginal propensity to withdraw of 0.25. Calculate the final change in output.
7. State one reason QE might fail to raise spending.
8. Distinguish symmetric from asymmetric targeting.
9. Explain why a credible target may lower wage claims.
10. State one reason why a rate rise may fail to reduce cost-push inflation.

Answers

1. 2.5 − 2.0 = 0.5 percentage points above target.
2. 4.0 − 2.5 = 1.5%.
3. 6/120 × 100 = 5.0%.
4. (2.50 − 2.00)/2.00 = +25% (appreciation).
5. Before: 40 × 2.00 = 80 fu. After: 40 × 2.50 = 100 fu. 80 fu rises to 100 fu.
6. Multiplier = 1/0.25 = 4. Output rises by 2 × 4 = 8 billion.
7. For example, banks may hold the extra reserves rather than lend, or firms may not borrow because confidence is low.
8. Symmetric: misses above and below the target count equally. Asymmetric: misses in one direction count as worse.
9. Expected inflation is a component of wage claims, so when people trust the target they expect lower inflation and ask for smaller rises.
10. The shock comes from supply (such as imported inputs), so cutting AD lowers output and jobs but does not reduce those costs.

Where marks are usually lost

• Stating that rates “reduce inflation” with no chain through spending and AD.
• Confusing a movement along AD with a shift.
• Using the wrong direction for exchange rate effects on exports.
• Giving the real interest rate as nominal plus inflation.
• Describing QE as the government printing cash.
• Listing limits of monetary policy without weighing them.
• Forgetting to apply the evaluation to the context in the question.
• Presenting the liquidity trap as a rate that cannot be changed rather than one where changes have no effect.
• Omitting units, or percentage points versus percent, in calculations.

Applying the ideas to a context

• Identify the cause of the inflation or slowdown before choosing a tool. Demand-pull cases suit a higher policy rate. Cost-push cases limit what rates can do.
• Check the level of rates. Well above zero, conventional changes work. Near zero, think of QE and expectations.
• Check the exchange rate channel. A small, open economy feels it strongly, because imports and exports are a large share of spending.
• Check credibility. If people trust the target, a small rate move may be enough because expectations do the work.
• Close with a judgement and name the condition it rests on.

Official syllabus

OCR, A Level in Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021, Macroeconomics: application of policy instruments, Monetary policy.