Macroeconomics - Monetary Policy
Case Study (hypothetical)- Level - IGCSE Example - 1
A country’s inflation rate rose to 8% in November from 4% compare to the last month. The central bank has increased the interest rate to 11%.
Analyze whether monetary policy can help to control the inflation in the country.
Possible answer -
Monetary policy is the use of interest rate and money supply to control the Aggregate demand in the economy. Monetary policy is used by the central bank of a country such Reserve Bank of India or Bank of England. Mostly to control the inflation in an economy or to manage the currency value a central bank might use monetary policy.
Same can be seen in the case as the country has increased its interest rate or base rate to 11% to counter the rise in inflation rate from 4% to 8% in the month of November. The increase in interest rate would make the borrowing costly. As a result, demand for durable goods will decrease due to increase in cost to consumers as they have to make higher interest payment. At the same time, firms will find it costlier to borrow and invest as higher interest will cause their profitability to be lower. This will cause investment spending to go down. Due to lower consumption spending and investment spending aggregate demand in the economy is likely to go down leading to fall in price level. (Just to mention that the consumption spending and the investment spending are component of aggregate demand. So anything letting them down would also let aggregate demand down.)
On the other hand, higher interest rate would also encourage people to save more as they can get more interest on their savings. This will lead the aggregate demand to go further down. Not only that, higher interest would also invite foreigners to bring their money into the country to save and earn more on their deposits. This will increase the demand for the currency leading to encouraging the domestic buyers to buy foreign goods as they would be quite cheaper. This will increase the competition in the market leading to lower demand for domestic goods and lower price level. Though this could be the subject to the quality of domestic and foreign goods and their necessity.
This is how the monetary policy can help to control the inflation in the economy.
Case Study (hypothetical) Example - 2
Level - IGCSE
Base rate in UK has gone down from 5% in the year 2008 to 0.25% in the year 2016. This has impacted the UK Economy in various ways.
 |
| Bank Rate UK |
(Source - https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate)
Discuss the impact of lowering interest rates on consumer spending.
Possible answer –
Before I get into the discussion let me first explain what interest rate is. Interest rate is the price of money that is borrowed or lent. Interest rates can be influenced by the central bank of a country through changing the base rate, though commercial banks do change the interest rates by their own in some cases.
Coming to the point, Surely, lowering interest rate will have greater impact on the consumer spending. If the interest rate is decreased by the central bank, then commercial banks are likely to follow them. This will cause less incentive for people to save money as they will get lower return on their savings. This will make the opportunity cost of saving high leading to consumers spending more on goods and services.
Besides that, a lowering interest rate may mean consumers finding it cheaper to borrow from banks to fund their consumption. Though the consumption will be limited to consumer durable goods such as home appliances and cars etc.
Lowering interest rate may also encourage people to take loans and buy houses as the lower interest rate policy may not last longer. This will increase the demand for housings leading to increase in demand for consumer durable goods further such as interiors and furnitures.
Along with that, lowering interest rate might influence the investment spending too. As the interest rate goes down entrepreneurs and firms may find it cheaper to borrow funds from banks and then start a new business or expand the existing ones. This increase in investment spending will cause further job opportunities among people leading to higher employment and income which may ultimately be used to fund the consumption.
In addition to that, lowering interest rate may cause the currency of a country to depreciate leading to higher exports and higher income. If this income from abroad is significant then it may cause further increase in consumer spending. However, depreciation in currency will make foreign goods costlier. As a result, consumption of imported goods may decrease.
0 Comments