top of page

2.5 Monetary policy: Interest rates 


Monetary policy: the use of interest rates and the money supply to influence the level of economic activity. 


The central bank usually controls the money supply, such as the UK’s Bank of England.


They are independent from the government, so they are less prone to political pressure from the government. 


The central bank sets the base/discount rate, which in turn influences the interest rate charged by financial institutions.


For instance NatWest will have an interest rate from mortgages above the base rate, but if the base rate, which they are charged, increases then they will also increase the interest that they charge.


The interest rate: the reward for saving and the cost of borrowing money, which is the price of money.


This is charged on mortgages, loans to businesses and credit cards. It depends on the risk involved for the lender, as well as the base rate.


The demand for money is due to the desire to buy goods and services and to hold it as assets.


The total demand for money is inversely related to the rate of interest.


The supply of money is not dependent on interest rates as it is determined by the central bank.


The central bank determines the level of supply in attempt to change interest rates. 


The role of monetary policy 


The central bank uses the following in order to adjust the money supply:


  • The base rate of interest

  • The reserve requirement

  • The purchase of government bonds



The base rate: the rate of interest the central bank charges on loans to the commercial banks.


The central bank is the lender of last resort, so loans to commercial banks when they cannot meet demands for consumers’ funds.


If the base rate decreases, commercial banks lower their interest rates so loans are less expensive and with more loans the money supply increases and interest rates across the whole economy falls. 


Reserve requirement: the central bank controls the amount of money that the commercial banks have to keep on deposit to meet the needs of their customers, in the UK it is 20% of the customer’s savings.


A decrease in the reserve requirement allows commercial banks to lend more of the money they receive as deposits, which increases money supply and interest rates.  


Sale and purchase of government bonds: a bond is an iou issued by the government in return and so represents a loan to the government. It guarantees the holder the repayment of the money, on a given date, with fixed annual interest.


The price of bonds depends on the demand and supply on the day – they are traded on the stock exchange.


The government may issue a large number of these to the commercial banks to reduce the money supply and interest rates. 


Expansionary/Reflationary/Loose monetary policy


This is designed to increase aggregate demand in the economy by increasing the money supply and reducing interest rates.


Lower interest rates will increase consumption and investment which are components of AD.   


To increase money supply and decrease the interest rate, the government will:

  • Lower the base rate

  • Decrease the reserve requirement

  • Buy bonds from banks, giving the commercial banks more money to lend. 


A decrease in interest rates will:


  • Decrease savings, as there is a lower reward

  • Increase consumption, as there is less incentive to save and real income increase as mortgages and loan repayments become less expensive

  • Increase investment, as borrowing to fund it is less expensive. 













Contractionary/Deflationary/Tight monetary policy


This is designed to decrease aggregate demand in the economy by decrease the money supply and increasing interest rates.


Higher interest rates will decrease consumption and investment which are components of AD.   


To decrease money supply and increase the interest rate, the government will:

  • Increase the base rate

  • Increase the reserve requirement

  • Sell bonds to banks, so banks have less to lend


An increase in interest rates will:


  • Increase savings, as there is a higher reward

  • Decrease consumption, as there is more incentive to save and real income decreases as mortgages and loan repayments become more expensive

  • Decrease investment, as borrowing to fund it is more expensive. 


Inflation targeting: the central banks of certain countries, rather than focusing on the maintenance of both full employment and a low rate of inflation, are guided in their monetary policy by the objective to achieve an explicit or implicit inflation rate target.













Evaluation of monetary policy


Argument against:


  • Time lags: monetary policy can be implemented fairly quickly compared to fiscal policy, however, the impact on the economy can take several months to come into effect.  


  • Business and consumer confidence: if confidence is low even low rates of inter will not encourage them to borrow to finance investment and consumption, as they may believe that in the future they will not be able repay the loans. 


  • Very low interest rates: when interest rates are very low, or close to zero, it is not possible to reduce the interest rates further, so other policies are needed (e.g. quantative easing).  


  • Conflicting goals: a deflationary monetary policy designed to reduce inflation can lead to slower economic growth and demand deficit unemployment.   


  • Unresponsive to change in interest rates: the demand for funds might be unresponsive if it is interest inelastic, meaning that a change in interest will have relatively little impact on the AD. 


Arugments for:


  • Speed: monetary policy can be enforced far more quickly than fiscal policy. For instance, in the UK the Monetary Policy Committee meets once a month to make decisions about the interest rate, whereas, fiscal policy may not be able to be changed until the annual budget.  


  • No politics: most central banks are independent from the government, so political desires about ensuring votes will not impact on the monetary policy.   


  • No crowding out: it does not borrow large sums of money which reduces the amount of private sector borrowing and so interest rates will not increase due to this, when they are intended to fall. 









































































bottom of page