AQA A-Level Economics (7136) · The National & International Economy
Specification points
- Monetary policy: interest rates, the money supply and quantitative easing.
- The role of the central bank (Bank of England) and the inflation target.
- The transmission mechanism and effects of monetary policy.
What is monetary policy?
Monetary policy uses interest rates and the money supply (including quantitative easing) to influence AD. It is run by the central bank, which targets inflation (around 2% in the UK).
- Expansionary (loose) — lower interest rates or QE → higher AD.
- Contractionary (tight) — higher interest rates → lower AD, fighting inflation.
The transmission mechanism
A change in interest rates affects AD through several channels: borrowing and saving, mortgage costs, business investment, the exchange rate and confidence.
Lower rates → more borrowing, spending and investment → higher AD (risk of inflation). Higher rates → less spending → lower inflation (risk of slower growth).
Key definitions
| Term | Definition |
|---|---|
| Interest rate | The cost of borrowing and reward for saving. |
| Quantitative easing | A central bank creating money to buy assets and raise the money supply. |
| Inflation target | The rate of inflation the central bank aims to achieve. |
Quantitative easing
When interest rates are already very low, the central bank may use QE — buying government bonds to increase the money supply, lower long-term interest rates and support lending and asset prices.
Worked example
With inflation above target, the central bank raises interest rates. Borrowing becomes dearer, mortgage costs rise and saving is more attractive, so households cut spending and firms invest less. AD falls, easing inflation — though growth may slow and unemployment rise, and there are time lags.
Common exam mistakes
- Confusing monetary (interest rates, central bank) with fiscal (spending/tax, government) policy.
- Getting the direction wrong — higher rates reduce spending.
- Ignoring time lags and the exchange-rate channel.
Exam technique
State the interest-rate change, trace the transmission mechanism to AD, then evaluate using time lags, confidence and the zero-lower-bound (why QE is used).
Quick revision
- Monetary policy = interest rates + money supply/QE (central bank).
- Lower rates → higher AD; higher rates → lower inflation.
- QE used when rates are near zero.