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

This guide covers monetary policy for OxfordAQA International AS and A-level Economics (9640), specification section 3.2.4.1, 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. All data are invented; the countries and currencies do not exist. Fiscal policy and supply-side policy are covered in their own sections.

Related pages: course hub · printable checklist · revision notes · practice questions · measurement of macroeconomic performance · diagnostics.

Coverage map

Outcome in 3.2.4.1	What you need to be able to do
Central bank acts on interest rates, money and credit, the exchange rate	Define monetary policy and name the levers
Objectives and targets	Explain the prime objective and the subsidiary ones
Interest rates to control inflation and affect activity	Trace the chain from a rate change to AD, output and prices
Exchange rate changes	Explain effects on AD and on each policy objective
Other instruments, including quantitative easing	Explain QE and say how it raises AD

You are not asked how interest rates and the exchange rate are set. You are asked what changes in them do to the economy. The quantitative skills in 3.5 can be tested in any unit, so the examples below use percentages, index numbers, real values and elasticity.

1. What monetary policy is

Monetary policy is the use of the central bank’s powers to influence three things: interest rates, the amount of money and credit in circulation, and the exchange rate. The bank usually sets one policy rate, and that rate feeds into what lenders charge and savers earn.

Many central banks have operational independence: the government sets the objective and the bank chooses how to meet it. This reduces the pull of short-term popularity, though unelected officials then make decisions that affect everyone.

2. Objectives and targets

The prime objective is usually to control inflation. Subsidiary objectives include moderating fluctuations in economic activity, which means leaning against booms and slumps.

A target turns the objective into a number. In the invented economy of Country A the target is 2.5% a year, with a tolerance of one percentage point either side, so the range is 1.5% to 3.5%.

Worked example: measuring against the target. Country A’s consumer price index (CPI) is 100 in Year 1, 103.9 in Year 2 and 108.2 in Year 3.

Year 2: (103.9 - 100) / 100 x 100 = 3.9%
Year 3: (108.2 - 103.9) / 103.9 x 100 = 4.1%

Both are above the 3.5% upper limit. The bank would consider tightening policy, though it also weighs forecast inflation, the output gap and the cause of the price rises.

A flexible inflation target lets the bank accept a small overshoot if the alternative is a deep recession. That is how the subsidiary objective works in practice. Other targets, such as money supply growth, are possible.

3. Interest rates: the transmission mechanism

A higher policy rate works through several channels:

1. Borrowing costs rise. Households on variable-rate loans keep less of their pay after interest, so consumption (C) falls.
2. Saving pays more, so some spending is postponed.
3. Investment (I) falls: loans are dearer and the return on saving is a better alternative for firms.
4. Asset prices, such as house prices, tend to fall, which reduces wealth and confidence.
5. The currency may appreciate as foreign savers move funds in, which cuts exports and raises imports.

Together these reduce aggregate demand (AD). In the AD/AS model the AD curve shifts left, so equilibrium real output falls and the price level ends up lower than it would have been. A rate cut does the reverse.

Worked example: the investment channel. A small bakery is considering a new oven costing 40,000 that should add 3,000 a year to profit, a return of 3,000 / 40,000 x 100 = 7.5%. If it must borrow at 6%, the oven pays for itself. If the rate rises to 8%, borrowing costs more than the oven earns, so the bakery cancels the purchase. Spread across many firms, that is a fall in investment.

Worked example: the size of the effect. In Country A there are 1 million households. Of these, 40% have variable-rate loans averaging 50,000. The policy rate rises by 0.75 percentage points and is passed on in full.

Variable-rate debt = 1,000,000 x 0.40 x 50,000 = 20bn
Extra interest = 20bn x 0.0075 = 150m
Per household: 50,000 x 0.0075 = 375 a year (31.25 a month)

A household with an after-tax income of 37,500 loses 375 / 37,500 x 100 = 1.0% of its income. Suppose households spend 70% of lost income, so consumption falls by 0.7 x 150m = 105m. Planned investment falls by 45m. The first-round fall in AD is 150m. The multiplier is 1.6, so:

Fall in real GDP = 150m x 1.6 = 240m
As a share of GDP of 40bn = 0.24 / 40 x 100 = 0.6%

Lower AD reduces demand-pull inflation.

Real interest rates. What matters to saving and borrowing is the real rate. With a nominal rate of 5.5% and inflation of 4.1%, the real rate is about 5.5 - 4.1 = 1.4%. The exact figure is (1.055 / 1.041 - 1) x 100 = 1.34%.

Linking to the output gap. If Country A’s actual output is 320 and potential output is 328, the gap is (320 - 328) / 328 x 100 = -2.4%. A negative gap means spare capacity and weak inflationary pressure, so a cut in rates is more likely. A positive gap suggests rising inflationary pressure, so a rise is more likely.

Evaluating interest rate policy

• Time lags. The full effect on spending and prices can take a year or more, by which time conditions may have changed.
• Size of the response. If most households have fixed-rate loans, or have large savings, consumption responds little. Low confidence can make firms ignore cheap credit.
• Cause of inflation. Higher rates do little about cost-push inflation, for example from a rise in world commodity prices. They cut output further without lowering costs.
• Conflicts. The same rise that lowers inflation raises cyclical unemployment and slows growth. This is why the bank must judge the trade-off, not apply a rule.
• Distribution. Borrowers lose and savers gain.
• Limits on cuts. When rates are already very low, there is little room to cut further, which is one reason for quantitative easing.

4. The exchange rate and macroeconomic performance

The exchange rate can be moved deliberately or as a side effect of other decisions. A fall in the currency’s value is a depreciation, and a rise is an appreciation.

Worked example: a depreciation. Country A’s currency is the A-unit and Country B’s is the B-unit. The rate falls from 1 A-unit = 0.90 B-units to 1 A-unit = 0.72 B-units.

Change in the A-unit: (0.72 - 0.90) / 0.90 x 100 = -20%
Value of a B-unit in A-units: 1.111 -> 1.389, a rise of 25%

Exports. A good priced at 150 A-units costs a foreign buyer 150 x 0.90 = 135 B-units before and 150 x 0.72 = 108 B-units after, a 20% fall. If price elasticity of demand (PED) for exports is -1.2, quantity demanded rises by 1.2 x 20 = 24%. With exports at 25bn A-units, receipts become 25 x 1.24 = 31bn.

Imports. A good priced at 45 B-units costs 45 / 0.90 = 50 A-units before and 45 / 0.72 = 62.5 after, a 25% rise. If PED for imports is -0.8, quantity falls by 0.8 x 25 = 20%. With imports at 22bn, spending becomes 22 x 1.25 x 0.80 = 22bn: unchanged because demand is inelastic.

Net exports: before 25 - 22 = +3bn; after 31 - 22 = +9bn
Rise in AD = 6bn; with a multiplier of 1.6, real GDP rises by 9.6bn
9.6 / 320 x 100 = 3.0% of GDP

Because net exports form part of AD, the AD curve moves right. The size of the gain depends on the elasticities. If both PEDs were low, the change could be small or even negative in the short run.

Cost side. If imported inputs are 15% of firms’ costs and import prices rise 25%, costs rise by 0.15 x 25 = 3.75% if fully passed on. This shifts short-run aggregate supply (SRAS) left.

Effect of a depreciation on each objective

Objective	Likely effect	Why
Economic growth	Rises	Net exports increase AD
Unemployment	Falls	Higher output needs more workers
Inflation	Rises	Demand-pull plus dearer imports
Current account	Improves if elasticities are high enough	Export volumes rise and import volumes fall
Living standards	Fall in the short run	Imports cost more

An appreciation has the opposite pattern: lower inflation and cheaper imports, but weaker exports, slower growth and more job losses in tradable industries. The bank can also trade in the foreign exchange market: selling its own currency for foreign currency tends to push the rate down, and buying it tends to push the rate up. This has limits, because reserves are finite and markets are large.

5. Other instruments, including quantitative easing

Other instruments include requiring banks to hold more reserves, limiting the credit banks may extend, and signalling future interest rate intentions to shape expectations. Quantitative easing (QE) is large-scale buying of government bonds by the central bank. It can raise AD because it increases the money supply and reduces interest rates.

Chain of reasoning.

1. The bank purchases bonds held by banks, pension funds and others, and pays with money it creates electronically.
2. Sellers’ deposits and reserves rise, so the money supply increases.
3. Extra demand for bonds raises their price, and the yield (the return to a new buyer) falls.
4. Lower yields feed through to lower borrowing costs, and sellers switch into other assets, raising share and property prices.
5. Consumption and investment rise, and a lower currency value may boost exports. The AD curve moves right.

Worked example. A government bond with a face value of 200 pays a fixed 9 a year and sells at 200. Its yield is 9 / 200 x 100 = 4.5%. Heavy buying pushes the price to 225, so the yield is 9 / 225 x 100 = 4.0%. Suppose the bank buys 36bn of bonds from non-bank holders when the money supply is 480bn. Their deposits rise, so the money supply becomes 516bn, an increase of 36 / 480 x 100 = 7.5%.

Evaluation.

• Banks may hold the extra reserves instead of lending, and firms may not borrow if confidence is weak.
• Higher asset prices benefit the wealthy more, which can widen inequality.
• The central bank ends up holding a large quantity of bonds, which must eventually be sold or allowed to mature.
• When spare capacity is small, a larger money supply can feed inflation.

Putting it together: an evaluative paragraph

“A cut in the policy rate lowers borrowing costs, raising consumption and investment, so AD shifts right and real output rises. This works best with spare capacity, because extra demand then raises output more than prices. However, cautious households and firms may respond little, and the effect may take over a year. If inflation comes from import prices, a cut could worsen it. The right call turns on the cause of the problem and the size of the output gap.”

Common errors

• Writing “the government sets interest rates”. In this unit the central bank carries out monetary policy.
• Saying a depreciation always improves the current account. It depends on elasticities and on time.
• Getting the direction wrong: after a depreciation, foreign buyers pay less for your exports, and you pay more for imports.
• Describing QE as printing money for the government to spend. The bank buys existing bonds.
• Using percentage points and percentages as if they were the same.

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.