Cambridge IGCSE Economics 0455
Syllabus points
- Define monetary policy.
- Explain how interest rates and the money supply affect the economy.
What is monetary policy?
Monetary policy is the use of interest rates and the money supply to influence the economy. It is usually run by the central bank.
- Expansionary (loose) monetary policy — lower interest rates (or more money supply) to boost demand.
- Contractionary (tight) monetary policy — higher interest rates to reduce demand and fight inflation.
Key definitions
| Term | Definition |
|---|---|
| Monetary policy | Using interest rates and the money supply to influence the economy. |
| Interest rate | The cost of borrowing and the reward for saving, as a percentage. |
| Money supply | The total amount of money in the economy. |
How interest rate changes work
A change in interest rates affects demand through several channels:
- Borrowing — higher rates make loans dearer, so households and firms borrow and spend less.
- Saving — higher rates reward saving, so people spend less.
- Mortgages — higher rates raise repayments, leaving less to spend.
- Investment — higher rates make it costlier for firms to fund new projects.
Lower interest rates → more borrowing and spending → more growth (but risk of inflation). Higher rates → less spending → lower inflation (but risk of slower growth).
Effects on the aims
- Cutting interest rates fights unemployment and slow growth, but may raise inflation.
- Raising interest rates fights inflation, but may slow growth and raise unemployment.
Worked example
Inflation is rising, so the central bank raises interest rates. Borrowing becomes more expensive, mortgage costs rise and saving becomes more attractive, so households cut spending. Lower demand eases the upward pressure on prices. The downside is that firms invest less and growth may slow.
Common exam mistakes
- Confusing monetary policy (interest rates, central bank) with fiscal policy (spending and tax, government).
- Getting the direction wrong — *higher* rates *reduce* spending.
Exam technique
State the direction of the interest rate change, trace how it affects borrowing, saving and spending, then link to the aims and evaluate the side effects.
Quick revision
- Monetary policy = interest rates + money supply (central bank).
- Lower rates → more spending/growth; higher rates → less spending/lower inflation.