Key Idea: Topic 3.5 explains how central banks use interest rates to influence AD. Monetary policy is the most commonly used tool for managing the business cycle in modern economies.
✅ Core definitions
- Monetary policy
- Central bank changes interest rates (and/or money supply) to influence AD and achieve macro objectives.
- Expansionary
- Lower interest rates → C↑, I↑ → AD shifts right (used in recessions, to close deflationary gap).
- Contractionary
- Higher interest rates → C↓, I↓ → AD shifts left (used to cool inflation, close inflationary gap).
- Inflation targeting
- Central bank targets ~2% inflation — anchors expectations, provides transparency.
⚙️ The transmission mechanism
- Lower rates → borrowing cheaper → consumption↑ and investment↑
- Lower rates → saving less attractive → spending↑
- Lower rates → currency depreciates → exports↑, imports↓ → (X−M)↑
- Lower rates → asset prices rise → wealth effect → spending↑
- All channels → AD shifts right → real GDP↑, price level↑
Monetary policy shifts AD, NOT AS. Always draw an AD shift on your diagram.
⚖️ Evaluation and limitations
✅ Strengths: Flexible and quick to implement. Independent (no political pressure). Effective for demand-pull inflation. Can be fine-tuned gradually.
❌ Limitations: Time lags (6–18 months for full effect). Blunt instrument (affects whole economy). Liquidity trap — at zero rates, further cuts useless. Cannot fix cost-push inflation or structural unemployment.
If rates are near zero and the economy is still weak → monetary policy is 'pushing on a string'. This is the liquidity trap (Japan 1990s-2020s).