What monetary policy is
Monetary policy is the use of interest rates and the money supply to influence the economy. In the UK it is set by the Bank of England rather than by the government, and its main target is the 2% inflation rate from 3.4.
That independence matters, and it is worth being able to explain. A government facing an election has a reason to keep interest rates low even when inflation demands otherwise. Handing the decision to the central bank removes that temptation, which makes the inflation target credible.
The distinction from fiscal policy is examined directly. Fiscal policy is spending and taxation, decided by the government. Monetary policy is interest rates and the money supply, decided by the central bank. Both change total demand, but through different levers and different hands.
- Monetary policy
- the use of interest rates and the money supply to influence the economy, set in the UK by the Bank of England rather than the government, with a main target of 2% inflation
How it affects growth, employment and price stability
The chain has to be spelled out, because the marks are in the steps rather than the conclusion.
A cut in interest rates makes borrowing cheaper and saving less attractive, so households borrow and spend more, and those with variable-rate mortgages have more left each month. Firms find that more investment projects now cover the cost of finance, so investment rises. Both raise total demand. Firms respond by producing more, which is economic growth, and producing more requires more workers, which reduces unemployment. But if demand rises faster than the economy can produce, the extra demand pushes prices up — demand-pull inflation.
A rise in interest rates runs the same chain backwards, and that is precisely how inflation is controlled: borrowing and spending fall, demand falls, and the upward pressure on prices eases. The cost is that growth slows and unemployment may rise.
That trade-off is the heart of the evaluation. Interest rates cannot serve every objective at once — the rate that controls inflation is the rate that slows growth. Which objective takes priority depends on which problem the economy actually has.
There is a further channel worth knowing, because it links to 4.3. Higher UK interest rates attract foreign savers looking for a better return, and they must buy pounds to save here. That raises demand for the pound, so the exchange rate rises — which makes imports cheaper and helps reduce inflation further, but makes UK exports dearer and harder to sell.
Worked example
Inflation has risen to 7%, well above the 2% target. Explain how the Bank of England would respond and evaluate the policy.
- Identify the objective at risk: price stability.
- The response is contractionary monetary policy — raising the interest rate.
- Trace the effect: borrowing becomes dearer and saving more rewarding, so consumers spend less.
- Higher mortgage payments leave households with less disposable income, reinforcing the fall in spending.
- Firms invest less because finance costs more, so total demand falls and the pressure on prices eases.
- Now the costs, which the evaluation needs.
- Lower demand means firms produce less, so growth slows and unemployment may rise; borrowers face real hardship.
Answer: The Bank would raise interest rates. Borrowing becomes more expensive and saving more attractive, so consumer spending falls; mortgage payments rise, cutting disposable income further; and firms cut investment because finance costs more. Total demand falls, reducing the pressure on prices and bringing inflation back towards target. The costs are that slower demand means slower growth and possibly higher unemployment, and households with mortgages face real difficulty. The policy is also slow — it can take many months to take full effect — and it will not work well if the inflation was cost-push, caused by higher import or energy prices rather than by excess demand.
Two limitations complete the evaluation. Monetary policy works with a long time lag, so a rate rise today affects inflation many months from now — which means the Bank is always acting on a forecast rather than on what is happening. And it is a blunt instrument: one interest rate applies to the whole economy, so it cannot help a struggling region without also slowing a booming one.
Common mistake
Monetary policy is not set by the government. In the UK the Bank of England sets interest rates independently, and confusing this with fiscal policy — which the government does control — is the standard error in this sub-topic.
Before you practise
- Monetary policy is the use of interest rates and the money supply, set by the Bank of England.
- Fiscal policy is spending and taxation, set by the government.
- The Bank's main target is 2% inflation.
- Lower rates raise borrowing, spending and investment, and reduce saving.
- Higher rates do the reverse, reducing demand and easing inflation.
- The chain is: interest rate, borrowing and saving, spending and investment, total demand, output and employment, prices.
- Controlling inflation with higher rates slows growth and may raise unemployment — the objectives conflict.
- Higher rates also raise the exchange rate, making imports cheaper and exports dearer.
- Monetary policy works with a long time lag and applies to the whole economy at once.
- It works poorly against cost-push inflation.