Who decides how much it costs to borrow? The central bank.
How monetary policy works
The central bank
The European Central Bank, the Bank of England, the US Federal Reserve.
Sets the interest rate
It raises or cuts the rate at which banks borrow from it.
Borrowing costs change
Loans and mortgages cost more, or less.
AD changes
Households and firms spend less or more: C and I change.
The points to remember
- Write it like this: "Monetary policy is the central bank's use of interest rates to change AD and keep inflation low."
- Most central banks are independent of the government: the Bank of England since 1997, the European Central Bank by treaty.
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A central bank uses one tool for several goals.
Five goals
Low and stable inflation
Most central banks aim for 2% a year.
Low unemployment
Enough spending to keep people in work.
Smaller booms and busts
Cool the economy in a boom, support it in a recession.
Stable conditions for growth
Predictable prices and rates help firms plan and invest.
External balance
A stable exchange rate and current account.
Remember it as: One tool, five goals: prices first.
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Inflation targeting is a simple rule: steer inflation back to the target.
Inflation targeting: one rule, three situations
| If inflation is | The central bank | So |
|---|---|---|
| 5%, above the 2% target | raises the interest rate | AD falls; inflation comes down |
| 0.5%, below the target | cuts the interest rate | AD rises; inflation goes up |
| 2%, on target | holds the rate | AD keeps growing steadily |
The points to remember
- Above target: raise the rate. Below target: cut it.
- A clear target also anchors expectations: if people expect 2%, wage and price rises stay moderate.
Paper 2 asked this in November 2024, the same at SL and HL, for 2 marks.
Define the term monetary policy.
Model answer plan
See the answer broken into clear points, with guidance on how each point earns marks.
How the 2 marks are given
| Your definition | Marks |
|---|---|
| Changes the money supply or interest rates in order to change AD or reach low inflation, growth, jobs | 2 |
| Only one idea: "changes interest rates", or "changes AD", or "aims at low inflation" | 1 |