Syllabus points
- Explain the role of a central bank and the goals of monetary policy.
- Explain how changing interest rates affects aggregate demand.
- Distinguish expansionary from contractionary monetary policy.
- Evaluate the strengths and limitations of monetary policy.
The role of the central bank
A central bank conducts monetary policy — usually independently of government — to achieve macroeconomic goals, above all low and stable inflation (often a target such as 2%), while supporting growth and employment. Its main tool is the policy interest rate; it may also use the money supply and, in a crisis, quantitative easing.
How interest rates affect AD
A change in the interest rate works through the components of AD:
- Consumption: lower rates cut the cost of borrowing and the reward for saving, raising C.
- Investment: lower rates make more projects profitable, raising I.
- Exchange rate: lower rates tend to weaken the currency, raising net exports (X − M).
So lower rates → higher AD, and higher rates work in reverse.
Expansionary vs contractionary
| Stance | Action | Aim |
|---|---|---|
| Expansionary | Cut interest rates / QE | Raise AD in a recession, reduce unemployment |
| Contractionary | Raise interest rates | Reduce AD to control demand-pull inflation |
Evaluation
- Strengths: flexible (rates can be changed quickly), set by independent experts free of the political cycle, and effective at anchoring inflation expectations.
- Limitations: time lags of up to 18 months; a liquidity trap where very low rates fail to stimulate spending; policy is powerless against cost-push inflation; and rate changes have uneven effects across borrowers and savers.
Worked example
Facing 6% demand-pull inflation, a central bank raises its policy rate from 2% to 4%. Higher borrowing costs reduce C and I, AD shifts left, and inflation eases — but with a lag, and at the cost of slower growth and possibly higher unemployment. If the inflation were cost-push, higher rates would do little to the cause.
Common exam mistakes
- Confusing monetary policy (central bank, interest rates) with fiscal policy (government, tax and spending).
- Assuming rate cuts always boost AD — ignore lags and the liquidity trap.
- Using monetary policy to "solve" cost-push inflation without qualification.
Exam technique
Trace the transmission from interest rates through C, I and net exports to AD, then evaluate lags and effectiveness for the specific type of inflation.
Quick revision
- Central bank targets low, stable inflation via the policy interest rate.
- Lower rates → higher C, I and net exports → higher AD.
- Expansionary (cut rates) vs contractionary (raise rates).
- Limits: lags, liquidity trap, ineffective against cost-push inflation.