Government and the Macroeconomy · 4 question types
Past paper frequency (2018 to 2024)
This topic accounts for approximately 16% of your exam marks.
Fiscal and monetary policy are core Section B evaluate topics; expansionary vs contractionary, tools and limitations tested consistently.
Monetary policy is the central bank's use of interest rates and the money supply to influence the economy.
The central bank is independent of the elected government in most modern economies (e.g. the Bank of England, the European Central Bank, the US Federal Reserve). Independence is meant to keep monetary decisions away from short-term political pressure.
The main tool is the base interest rate the central bank charges on its loans to commercial banks. Changes in the base rate flow through to all other interest rates in the economy: mortgages, business loans, savings accounts, credit cards.
When the central bank raises interest rates, borrowing becomes more expensive and saving becomes more attractive. Households and firms spend less and save more, so aggregate demand falls.
What follows:
The combined effect is lower aggregate demand, which slows demand-pull inflation. Higher rates are the central bank's main weapon against inflation.
When the central bank cuts interest rates, borrowing becomes cheap and saving becomes unattractive. Households and firms spend and invest more, so aggregate demand rises.
What follows:
The combined effect is higher aggregate demand, which lifts growth and reduces unemployment. Lower rates are the central bank's main weapon in a recession.