Monetary Policy Measures

Exam code: 2281

Written by: Ashika|Reviewed by: Caroline Carroll|Updated 2 July 2026

Understanding monetary policy

Understanding monetary policy

Monetary policy involves adjusting the money supply so as to influence total (aggregate) demand
- The money supply is the amount of money in an economy at any given moment in time
- It consists of coins, banknotes, bank deposits and central bank reserves
The Central Bank in each economy is responsible for setting monetary policy
- The Bank's Monetary Policy Committee usually meets 4-8 times a year to set policy

The three main instruments of monetary policy

The three main instruments of monetary policy

1. Changes in interest rates

The central bank can raise interest rates to make borrowing more expensive and saving more attractive, slowing total demand and inflation
It can lower interest rates to make borrowing cheaper, encouraging spending and investment and boosting growth

2. Changes in the money supply

Increasing the money supply (e.g., through quantitative easing) can encourage more lending and spending
Reducing the money supply can slow down total demand and help control inflation

3. Changes in the foreign exchange rate

A lower exchange rate makes exports cheaper for foreign buyers and imports more expensive, boosting total demand for domestic goods and improving the balance of payments
A higher exchange rate makes imports cheaper, which can reduce inflation but may hurt export competitiveness

The effects of monetary policy on government macroeconomic aims

The effects of monetary policy on government macroeconomic aims

When a policy decision is made, it creates a ripple effect through the economy, impacting the macroeconomic objectives of the government
To understand the effects of monetary policy on an economy, it is useful to know how total demand (gross domestic product) is calculated
Total (aggregate) demand = household consumption (C) + firms' investment (I) + government spending (G) + exports (X) - imports (M)

$Total demand = C + I + G + (X - M)$

From this, it is logical that changes to monetary policy can influence any of these components – and often several of them at once
- Economic growth
  - Lower interest rates and increased money supply boost spending and investment
- Low inflation
  - Higher interest rates and reduced money supply can slow price rises
- Low unemployment
  - Expansionary monetary policy creates demand, leading to job creation
- Healthy balance of payments
  - Adjusting exchange rates can improve trade competitiveness
- Sustainability
  - Low-interest loans for green projects or incentives for clean technology investment can support environmental goals

Examples of monetary policy

Examples of monetary policy

Examples of contractionary monetary policy

Example 1

The Central Bank increases interest rates

Effect on the economy

Existing loan repayments for households become more expensive → discretionary income reduces → consumption decreases → total demand falls
Firms are less likely to borrow → less investment in capital takes place → total demand falls
Hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → total demand decreases

Impact on macroeconomic aims

Economic growth slows down
Inflation eases
Unemployment may increase as output is falling and fewer workers are required
Current Account is likely to worsen as both exports and imports reduce (exports more expensive and imports cheaper - but households have less income for imports)

Examples of expansionary monetary policy

Example 1	The USA Federal Reserve Bank commits to $60bn a month of quantitative easing
Effect on the economy	Commercial banks receive cash for their bonds → liquidity in the market increases → commercial banks lower lending rates → consumers and firms borrow more → consumption and investment increase → total demand increases
Impact on macroeconomic aims	Economic growth increases Inflation rises Unemployment may fall as output is increasing and more workers are required Current Account worsens (with more income, imports may rise)

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