Fiscal & Monetary Policy

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.

Higher interest rates: contractionary monetary policy

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:

• Mortgage payments rise → households have less disposable income.
• Business loans are more expensive → firms invest less.
• Saving is more attractive → households save more, spend less.
• The currency often strengthens (foreign investors want higher-yielding assets in this country) → imports become cheaper, exports more expensive.

The combined effect is lower aggregate demand, which slows demand-pull inflation. Higher rates are the central bank's main weapon against inflation.

Lower interest rates: expansionary monetary policy

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:

• Mortgage payments fall → households have more disposable income.
• Business loans are cheaper → firms invest more.
• Saving is less attractive → households spend more.
• The currency often weakens → exports cheaper abroad.

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.

Other monetary tools

• Quantitative easing (QE). The central bank creates new money to buy government bonds (and sometimes corporate bonds), pushing more cash into the financial system. Used when interest rates are already near zero.
• Money-supply changes. Some central banks directly control the amount of money in circulation, though this is less common in advanced economies.

Limitations of monetary policy

• Time lags. It takes 6–18 months for a rate change to feed fully through to spending and inflation. The central bank has to act on its forecast, not on what is happening today.
• Confidence matters. If households and firms are pessimistic, cheap loans alone may not persuade them to spend. (The "you can lead a horse to water…" problem.)
• The liquidity trap. When rates are already near zero, the central bank cannot cut them much further. Monetary policy loses traction. This was the position of many central banks for most of the 2010s.
• Effects on the housing market. Rate changes have large and sometimes unintended effects on house prices, which complicates social policy.