4.4.2 - Monetary policy measures
This section of the Cambridge IGCSE Economics (0455) syllabus requires students to understand the following monetary policy measures, namely changes in: (1) interest rates, (2) the money supply, and (3) foreign exchange rates.
The central bank is the monetary authority of a country or territory with responsibility for the economy's monetary policies measures. Essentially, the central bank oversees a country’s banking system by managing its money supply and interest rates.
1. Changes in interest rates
The term "interest rate" refers to the price of money in terms of the return for lenders of money or in terms of borrowing money, expressed as a percentage of the money loaned or borrowed.
The use of interest rate policy is the main monetary policy measure used by monetary authorities across the world. It refers to the use of interest rates to influence or regulate the level of economic activity (GDP). For example, during an economic recession, the monetary authority is likely to reduce interest rates. This makes the cost of borrowing more affordable for individuals and households, as well as for firms. Hence, lower interest rates tend to encourage more consumer spending and higher levels of investment expenditure. Lower interest rates also reduce the incentive for people to save, which also helps to encourage more spending, which can help the economy to get out of a recession.
Lower interest rates are used to stimulate more spending in the economy
By contrast, higher interest rates make borrowing more expensive. It can also create more of an incentive for people to save money. Therefore, a hike in interest rates tend to reduce the overall level of economic activity. The purpose of this is to reduce inflationary pressures in the economy (see Unit 4.8). For example, in March 2024, the Turkish government raised interest rates to 50% in its attempt to reduce the country's high annual inflation rate of 68.5%.
Did you know...?
Did you know that in 2024, the US federal government spent 13% of its $3.25 trillion budget on debt interest? This is about the same amount allocated to the US government's annual expenditure on national defence. In contrast, the government spent only 3% of its budget on education, training, employment, and social Services (combined).
Source: US Treasury
Case Study - Negative interest rates
During the COVID-19 pandemic, central banks around the world lowered interest rates in an attempt to counteract the detrimental impacts of border closures and national lockdowns. During this time, some countries, including Denmark and Switzerland, as well as the European Central Bank (ECB), introduced negative interest rates in an attempt to stimulate economic activity.
Negative interest rates exist when nominal interest rates fall below zero. This means people have to pay in order to save their money in a bank. The purpose of using negative interest rates is to stimulate the economy, by discouraging savings.
In the immediate post-COVID era, central banks around the world, including the US Federal Reserve and the UK’s Bank of England, have aggressively raised interest rates to restrain escalating prices.
2. Changes in the money supply
The money supply refers to the total amount of money in circulation or existence in the economy at a particular point in time. A second monetary policy measure is for the government or central bank to control the economy's money supply to influence or regulate the level of economic activity (GDP).
For example, the central bank can change the reserve ratio (see Unit 3.1) to control how much money commercial banks are able to lend. The reserve ratio is the proportion of money that commercial banks are required to place at the central bank to support the economy's banking system, such as banks settling payments with each other. Reducing the reserve ratio means that commercial banks can lend more of their money, leading to an increase in the supply of money. The purpose is to stimulate consumption and investment expenditure in the economy. The opposite applies if the central bank raises the reserve ratio to contract the level of economic activity.
However, due to the broad definition of money (see Unit 3.1), direct control of the money supply is challenging in reality. Hence, most governments rely on interest rate policy to influence economic activity.
3. Changes in foreign exchange rates
A third monetary policy measure is the use of exchange rates. An exchange rate is the price of the domestic currency in terms of other currencies, e.g., $1 = €0.98 = £0.83 = ¥134.8. Due to international trade and globalisation, foreign currency exchange has a direct impact on the economy's money supply. For example, US tourists visiting Paris need to purchase euros to complete their transactions in France. All things being equal, this increases the money supply in France and reduces the money supply in the US. Therefore, the buying and selling of foreign currencies (which cause changes to foreign exchange rates) has a direct impact on the domestic economy's money supply.
However, due to the sheer volume and complexities of international trade, trying to regulate foreign exchange rates (see Unit 6.3) is also rather challenging in reality. Hence, the most commonly used monetary policy measure is changes in interest rates.
How does raising interest rates control inflation?
Watch this educational video from The Economist and answer the questions that follow.
Why should you care about rising interest rates?
What are interest rates (and why does a single interest rate not exist)?
What do central banks do?
Why do central banks raise interest rates?
How do raised interest rates affect consumers?
How do raised interest rates affect businesses?
What are the risks of raising interest rates?
How do interest rates affect inflation?
To test your understanding of this topic in the Cambridge IGCSE Economics syllabus (Monetary policy measures) review the text above and then answer the following questions.
What is the main monetary policy measure used by monetary authorities across the world?
How does a reduction in interest rates affect the economy during a recession?
What effect do higher interest rates have on the overall level of economic activity?
Why does the government or central bank control the economy's money supply?
How can the central bank change the money supply?
What is the reserve ratio?
What happens when the central bank reduces the reserve ratio?
What is the most commonly used monetary policy measure to tackle the problem of demand-pull inflation?
How do changes in foreign exchange rates impact the domestic economy's money supply?
Why is trying to regulate foreign exchange rates challenging in reality?
Teacher only boxAnswers
1. What is the main monetary policy measure used by monetary authorities across the world?
Interest rate policy
2. How does a reduction in interest rates affect the economy during a recession?
It makes the cost of borrowing more affordable for individuals, households, and firms, which encourages more consumer spending and higher levels of investment expenditure, thereby helping the economy to get out of a recession.
3. What effect do higher interest rates have on the overall level of economic activity?
They tend to reduce the overall level of economic activity by discouraging borrowing to fund consumption and investment expenditure.
4. Why does the government or central bank control the economy's money supply?
To influence or regulate the level of economic activity (GDP).
5. How can the central bank change the money supply?
By changing the reserve ratio to control how much money commercial banks are able to lend to their customers.
6. What is the reserve ratio?
This is the proportion of money that commercial banks are required to place at the central bank to support the economy's banking system, such as banks settling payments with each other.
7. What happens when the central bank reduces the reserve ratio?
Commercial banks can lend more of their money, leading to an increase in the supply of money, stimulating consumption and investment expenditure in the economy.
8. What is the most commonly used monetary policy measure to tackle the problem of demand-pull inflation?
Higher interest rates, used to reduce the level of consumption and investment expenditure in the economy (due to the relatively higher cost of borrowing), thereby tackling the issue of demand-pull inflation.
9. How do changes in foreign exchange rates impact the domestic economy's money supply?
The buying and selling of foreign currencies, which cause changes to foreign exchange rates, has a direct impact on the domestic economy's money supply.
10. Why is trying to regulate foreign exchange rates challenging in reality?
Due to the sheer volume and complexities of international trade across the world.
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