5.3 Monetary policy
- Syllabus
- 9708–2026–2027
- Topic
- 5.3
- Level
- AS
Learning objectives
5.3.1Monetary policy• Definition of monetary policy5.3.2Monetary policy tools• Tools of monetary policy: interest rates, money supply and credit regulations5.3.3Monetary policy stance• Distinction between expansionary and contractionary monetary policy5.3.4Monetary policy in AD/AS• AD/AS analysis of the impact of expansionary and contractionary monetary policy on the equilibrium national income and the level of real output, the price level and employment
What monetary policy controls
Monetary policy is the management of interest rates, the money supply and credit conditions to influence economy-wide objectives such as price stability, real output and employment. It is normally implemented by a country’s central bank.
| Policy family | Main instruments |
|---|---|
| Monetary policy | Interest rates, money supply, credit regulations |
| Fiscal policy | Government spending and taxation |
The policy decision changes financial conditions first. Households, firms and banks then respond, so the eventual effect on aggregate demand and inflation is indirect and may take time.
Monetary policy is not any government action involving money. Taxes and public spending are fiscal policy. An exchange-rate change may be a transmission effect of interest rates, but the three required AS tools are stated above.
Use interest rates, money supply and credit regulations
| Tool | Expansionary change | Contractionary change | Immediate mechanism |
|---|---|---|---|
| Interest rate | Lower policy/lending rates | Higher rates | Changes cost of borrowing and reward for saving |
| Money supply | Increase liquidity/money available | Reduce it | Influences bank reserves, interest and spending capacity |
| Credit regulations | Relax lending limits or reserve/credit restrictions | Tighten them | Changes availability and conditions of bank credit |
Lower rates, more money and easier credit are intended to encourage household consumption and firm investment. The opposite changes restrain borrowing and spending. Central-bank purchases or sales of government securities can be one way to alter liquidity, but the syllabus tool category is the money supply.
If a central bank lowers reserve requirements, banks can support more lending: credit becomes more available and monetary policy is expansionary. Raising lending rates and tightening credit limits is contractionary.
Increasing credit regulation means tighter, not easier, credit unless the stated rule itself expands lending. Government spending, taxes, tariffs and wage controls are not monetary-policy tools.
Distinguish expansionary and contractionary monetary policy
| Stance | Consistent instrument changes | Intended demand effect | Typical situation |
|---|---|---|---|
| Expansionary (loose/reflationary) | Interest rates down; money supply up; credit restrictions relaxed | Encourage borrowing, consumption and investment; AD pressure rises | Recession, deflation or high cyclical unemployment |
| Contractionary (tight/deflationary) | Interest rates up; money supply down; credit restrictions tightened | Encourage saving/restrain borrowing and spending; AD pressure falls | Demand-pull inflation or overheating |
A central bank responding to deflation by cutting rates and increasing the money supply is expansionary. A central bank responding to inflation by raising rates or selling government bonds to reduce liquidity is contractionary.
Classify the stance from the direction of the monetary instruments, not from fiscal balances or taxes. A depreciation may accompany expansionary policy, but it is not required as one of the three tool changes in this objective.
Use AD/AS to analyse monetary-policy outcomes
Trace monetary policy in four moves: identify the tool and stance; explain how borrowing, saving, lending or the exchange rate changes C, I or net exports; shift AD; read the new equilibrium national income/real output, price level and employment.
| Policy and AD shift | National income/real output | Price level | Employment |
|---|---|---|---|
| Expansionary → AD right | Usually rises | Usually rises / deflation pressure eases | Usually rises; cyclical unemployment falls |
| Contractionary → AD left | Usually falls | Usually falls / inflation pressure eases | Usually falls; unemployment rises |
For example, a rate cut makes borrowing cheaper and saving less rewarding, tending to raise C and I. It may cause capital outflow and currency depreciation, which can raise net exports if trade quantities respond. A rate rise works broadly in reverse and may also reduce import-cost inflation through appreciation.
With spare capacity, expansion can raise output and employment with little inflation. Near full employment, the same AD rise is more inflationary. Contraction is most effective against demand-pull inflation when spending is interest-sensitive; it is weaker against a physical supply shock and may reduce output and employment.
Direction is clearer than size. Success depends on confidence, bank lending, debt, interest sensitivity, exchange-rate regime, time lags, AS position and inflation's cause. Monetary expansion does not add to government debt by itself or instantly raise productive capacity.