Why do governments leave the economy's steering to the central bank?
Why central banks like it
Small steps
Rates move by 0.25 points at a time.
Easy to reverse
A rise can be undone next month if the economy weakens.
Quick to decide
The central bank meets every few weeks; no new law is needed.
Free of politics
An independent bank is not ruled by the election calendar.
The points to remember
- Strengths in four words: incremental, flexible, reversible, quick.
- An independent bank's 2% promise is believed, so expectations stay low.
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Monetary policy also has limits.
Where it struggles
Rates near zero
From 2009 many rates were close to 0%, with little room left to cut.
Low confidence
In a deep recession, cheap loans do not tempt worried firms and households.
Cost-push inflation
Higher rates cut AD, so prices fall only by cutting output and jobs.
Slow to work
A rate change can take a year or more to reach inflation.
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Remember it as: Interest rates steer demand; they cannot fix costs.
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History gives three tests.
Three real tests
United States, 1979-1982
Rates near 20% cut inflation from about 13.5% to about 3%, but unemployment rose to almost 11%.
2008-2009
Rates were cut to near zero, yet recovery was slow: confidence was low.
Euro area, 2022-2023
Rate rises helped bring inflation down from about 10.6% to 2.4% within a year.
The points to remember
- Effective against demand-pull inflation; weak against cost-push inflation.
- Weak in a deep recession: rates near zero, confidence low.
Paper 1 asked this in May 2024, as part (b) for 15 marks; the specimen paper asked the same.
Using real-world examples, discuss the effectiveness of monetary policy in reducing the rate of inflation.
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How the 15 marks are given
| Marks | What your answer needs |
|---|---|
| 13–15 | Theory fully explained, terms right all the way through, balanced evaluation, real examples fully developed to support the argument |
| 10–12 | Theory explained, terms mostly right, evaluation mostly balanced, real examples developed |
| 7–9 | Theory partly explained, some evaluation but one-sided, examples partly developed |
| 4–6 | Theory only described, evaluation superficial, examples only named |
| 1–3 | Theory stated but not relevant, no evaluation |