In a recession, the central bank cuts its interest rate.
A rate cut, step by step
Rate cut
The central bank lowers its interest rate.
Cheaper loans
Mortgages and business loans cost less; saving pays less.
More C and I
Households spend more; firms invest more.
AD right
Real GDP rises and unemployment falls.
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In a boom, it raises the rate to bring inflation down.
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The points to remember
- Write it like this: "Higher interest rates raise the cost of borrowing, so consumption and investment fall and AD shifts left."
- Monetary policy shifts AD, not AS.
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The same change runs through the whole economy.
A rate rise and the circular flow
Investment falls
Firms borrow less to buy machines: an injection falls.
Saving rises
Households save more of their income: a leakage rises.
Less spending
Less income flows from households to firms.
A smaller flow
National income and output shrink.
The points to remember
- Higher rates can also attract money from abroad: the currency appreciates, so exports fall.
- Lower rates do the opposite: the currency depreciates and exports rise.
Remember it as: Rates up: less borrowing, less spending, AD left.
Paper 2 asked this in November 2023, May 2024 and May 2025, for 4 marks.
Using an AD/AS diagram, explain why a contractionary monetary policy may reduce inflation.
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How the 4 marks are given
| Marks | What your answer needs |
|---|---|
| 3–4 | A correct diagram and a correct explanation |
| 1–2 | A correct diagram or a correct explanation, not both |
| 3 at most | A diagram with a wrong or missing label |