Monetary policy
Monetary policy
- Monetary policy is run by the central bank. Main tool: the interest rate (also money supply, exchange rate).
Practice
The main tool of monetary policy is the:
The central bank's main tool is the interest rate (it can also change the money supply or exchange rate).
The transmission mechanism
- If the central bank raises the interest rate:
- borrowing is dearer → households and firms spend/invest less,
- saving is rewarded → people spend less,
- the currency tends to rise → exports fall.
- All three lower AD, slowing inflation. A cut does the opposite.
Practice
Raising the interest rate tends to:
A higher rate cuts spending, investment and exports, lowering AD and slowing inflation.
Effectiveness
- Flexible (the rate can change anytime), but works with a time lag of a year or more.
- In a deep slump, even very low rates may not make worried firms/households borrow.
Practice
Monetary policy is flexible but works with a time lag of a year or more.
The rate can change anytime, but its full effect on the economy takes a year or more.
You've got it
Key idea
- monetary policy = the central bank setting the interest rate
- a higher rate cuts spending, investment and exports → lower AD → slower inflation
- it's flexible but has a time lag and may fail in a deep slump