OxfordAQA International AS and A-level Economics: Monetary policy (9640) – Revision Notes

These notes condense specification section 3.2.4.1 (Monetary policy) of OxfordAQA International AS and A-level Economics (9640), for exams from May/June 2021 (International AS) and May/June 2022 (International A-level). Everything here sits in International AS section 3.2, which the full International A-level also includes. For the explanations behind these notes, use the study guide. Test yourself with the practice questions, find your gaps with the free diagnostics, and tick off outcomes on the checklist. The course home page is the OxfordAQA Economics hub. All data are invented.

Key terms

Term	Meaning
Monetary policy	The central bank using its tools on borrowing costs, the quantity of money and credit, and the currency’s value
Policy rate	The central bank’s own rate, which sets the level for what lenders charge and savers earn
Inflation target	A numerical objective for the inflation rate, often with a tolerance range
Real interest rate	The return on saving or cost of borrowing after allowing for rising prices
Depreciation / appreciation	A fall / rise in the value of the currency against another currency
Quantitative easing (QE)	Large-scale purchase of government bonds by the central bank, raising the money supply and lowering interest rates
Output gap	The gap between actual and potential output, as a percentage of potential

Objectives and targets

• Prime objective: usually to control inflation.
• Subsidiary objectives: moderating fluctuations in economic activity (stabilising growth and employment).
• A flexible target tolerates temporary overshoots when the alternative is a large loss of output.
• You do not need to explain how interest rates or exchange rates are determined. You need to explain what happens when they change.

Interest rate chain (rise)

1. Policy rate up, so loan rates up and saving rewards up.
2. Borrowers on variable rates pay more interest and have less left to spend, so consumption falls.
3. Investment falls: higher cost of funds and lower expected returns.
4. Asset prices fall, so wealth and confidence fall.
5. Currency may appreciate, so exports fall and imports rise.
6. AD shifts left. Output and employment fall, and inflationary pressure eases.

A cut reverses every step. Always finish the chain with the effect on the price level or output.

Evaluation points for interest rates

Point	Reasoning
Time lag	Effects on spending and prices take time, so decisions rest on forecasts
Strength of response	Fixed-rate debt, large savings or low confidence weaken the effect
Cause of inflation	Lower demand does not cut costs, so tackling cost-push inflation this way loses output
Conflicting objectives	Lower inflation may mean higher unemployment and slower growth
Winners and losers	Savers gain from rises, borrowers gain from cuts
Limit on cuts	Little room when rates are already very low

Exchange rate effects

Change	AD	Inflation	Growth and jobs	Current account
Depreciation	Net exports rise, AD right	Up: dearer imports and demand-pull	Up	Better if elasticities are high enough
Appreciation	Net exports fall, AD left	Down: cheaper imports	Down	Worse if elasticities are high enough

Diagram in words: sketch AD and AS with the price level on the y-axis and real GDP on the x-axis. A depreciation moves AD out to the right, so both the price level and real GDP rise. If imported inputs are significant, SRAS also shifts left, so output gains are smaller and the price rise is larger.

The central bank can also deal in the currency market. Selling its own currency tends to lower the rate, and buying it tends to raise the rate, but it can only keep buying while its reserves last.

Exchange rate chain to learn

Rate falls, so export prices fall in foreign currency and import prices rise in home currency. Export volumes rise by the PED of exports times the price fall; import volumes fall by the PED of imports times the price rise. Net exports change, AD shifts, and the multiplier amplifies the final change in real GDP. Judge the result by elasticity, the time taken and the size of spare capacity.

QE in five steps

1. Central bank buys government bonds from banks and other holders.
2. It pays with newly created money, so deposits and reserves rise.
3. Bond prices rise and yields (interest rates) fall.
4. Cheaper borrowing and higher asset prices raise consumption and investment.
5. AD shifts right.

Evaluation: banks may hold reserves rather than lend; firms may not borrow if confidence is low; asset-price gains help the wealthy most; the bank must later manage its bond holdings; a larger money supply can feed inflation when spare capacity is small.

Model evaluation sentence to adapt

“A rise in the policy rate should reduce demand-pull inflation, but its effect depends on how much household debt is variable-rate and how quickly spending responds. If inflation comes mainly from import costs, higher rates reduce output without lowering costs, so the policy is less suitable and the cost in lost jobs is higher.”

Method boxes

Percentage change = (new - old) / old x 100. The starting value is the base. A percentage point is the gap between two percentages.

Inflation from an index: (index this year / index last year - 1) x 100.

Real rate (approximate): nominal - inflation. Exact: (1 + nominal) / (1 + inflation) - 1.

Multiplier: 1 / marginal propensity to withdraw. Total effect on GDP = first-round change in AD x multiplier.

Bond yield: annual payment / price x 100.

Import pass-through: share of imported inputs in costs x percentage rise in import prices.

Worked reminders

• CPI of 250.0, then 256.5, then 259.8 gives 256.5 / 250.0: 2.6%, then 259.8 / 256.5: 1.3%.
• A nominal rate of 7.5% with inflation of 3.0% gives a real rate of about 4.5% (exact: 1.075 / 1.03 - 1 = 4.4%).
• A bond paying 12 a year at a price of 150 yields 8.0%. If the price rises to 200, the yield is 12 / 200 x 100 = 6.0%.
• Imported inputs are 18% of costs and import prices rise 8%: costs rise by 0.18 x 8 = 1.44% with full pass-through.

Must-know distinctions

• Interest rate vs money supply: rates are the price of credit; QE increases quantity of money.
• Depreciation vs falling prices: a falling currency makes imports dearer in home currency, so it is not the same as deflation.
• Nominal vs real: a rate of 3% means little without the inflation rate.
• Demand-pull vs cost-push: monetary policy works on demand. It cannot lower costs directly.
• Prime vs subsidiary objective: inflation control comes first; stabilising activity is secondary.

Quick self-test

1. Define monetary policy.
2. A price index is 250.0 in Year 1, 256.5 in Year 2. Calculate inflation in Year 2.
3. The nominal interest rate is 7.5% and inflation is 3.0%. Estimate the real rate.
4. Actual output is 188 and potential output is 200. Calculate the output gap.
5. A firm has a variable-rate loan of 72,000. The rate rises from 5% to 8%. Calculate the extra annual interest and the extra monthly interest.
6. The firm’s annual profit is 24,000. Express the extra interest as a percentage of profit.
7. The first-round fall in AD is 0.6bn and the MPW (marginal propensity to withdraw) is 0.2. Calculate the fall in real GDP.
8. A currency falls from 1.20 to 0.90 units of a foreign currency. Calculate the percentage change in its value.
9. A bond pays 12 a year and its price rises from 150 to 200. Calculate the new yield.
10. Give one reason why QE may leave spending almost unchanged.
11. Imported inputs are 18% of costs and import prices rise 8%. Calculate the maximum rise in costs.

Answers

1. Central bank action on borrowing costs, the quantity of money and credit, or the exchange rate.
2. (256.5 - 250.0) / 250.0 x 100 = 2.6%.
3. 7.5 - 3.0 = about 4.5%.
4. (188 - 200) / 200 x 100 = -6.0%, a negative gap.
5. 72,000 x 0.03 = 2,160 a year, which is 180 a month.
6. 2,160 / 24,000 x 100 = 9.0%.
7. Multiplier = 1 / 0.2 = 5. Fall = 0.6 x 5 = 3.0bn.
8. (0.90 - 1.20) / 1.20 x 100 = -25%. The foreign currency has risen by 33.3% against it.
9. 12 / 200 x 100 = 6.0%.
10. Banks may hold the new reserves instead of lending; firms may not want to borrow when demand is weak.
11. 0.18 x 8 = 1.44%.

Where marks are usually lost

• Stopping a rate-change explanation before it reaches AD, output or prices.
• Treating a depreciation as always good for the current account without mentioning elasticities.
• Evaluating with a list of points and no judgement on which matters most.
• Dividing a change by the finishing figure instead of the starting figure.
• Confusing a percentage with a percentage point.
• Using “the government” when the central bank carries out monetary policy.
• Describing QE as printing money for the government to spend.
• Recommending a rate rise for cost-push inflation while ignoring the lost output.
• Leaving out the time lag and the size of the output gap in an evaluation.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), version 1.2, published by OxfordAQA: section 3.2.4.1 Monetary policy and section 3.5 Quantitative skills.