While fiscal policy deals with government spending and taxation, monetary policy is concerned with the supply and demand of money. This may sound strange but it is actually relatively straightforward. Like any other product, the supply and demand of money is, on a day-to-day basis, governed by the price of money, that is, the interest rate. By studying monetary policy, you will learn both how the opportunity cost of spending as well as the cost of borrowing money can be influenced simply by adjustment of the interest rate.
The interest rate and the central bank
The interest rate that we talk about in Economics may be a bit different from the way your perceive interest rates in your everyday life. You are probably aware of the fact that you receive interest on the money deposited in your savings account, and that you have to pay interest when you borrow money from the bank. However, different banks set different interest rates in order to compete for your money. You will want to borrow money from the bank that offers the lowest lending-rate and deposit money with the bank that offers you the highest interest on your savings. In other words, this is just like normal competition for consumers like in any other market.
The banks are, in turn, however governed by the by the central interest rate. This is the interest rate set by the central bank. It acts as a guideline in the sense that it determines how much the normal, commercial banks, can gain if they deposit money with the central bank. In other words, when we say that the interest rate increases, we really mean that the interest set by the central bank increases. This means that commercial banks can get more money from depositing money with the central bank, and so, they will, in turn, charge a higher interest when lending money to consumers. On the other hand, they will pay more interest to consumers who deposit money with them since they can use this money to receive interest from the central bank themselves.
Example When the Bank of England increases the interest rate from 1% to 2%, it means that NatWest, Barclays, Lloyd’s and HSBC (british banks) can get more interest on the money they deposit with the Bank of England. As a result, they will want to get hold of more money from consumers. In order to do so, they all increase the interest payable to consumers on their savings, for example from 0.5% to 1%. Consumers will seek to deposit money with the bank that gives them the highest interest rate, and so, there may well be competition for consumers among the banks. Similarly, the banks will now raise the cost of loans since the opportunity cost of lending to consumers has increased. Thus, while the interest rate set by the central bank is not the rate that consumers will pay, the central interest rate nevertheless influences what consumers and firms pay and receive.
Why the central bank?
You may well ask yourself why there is a central bank in a country and why it is made responsible for managing the interest rate. The fact is that the government could, in theory, handle the interest rate itself. However, there are obvious problems with such an arrangement since a government will always have its own agenda. For example, a government may well be willing to sacrifice long-term economic performance for the benefit of doing well in an upcoming election by keeping interest rates low. As a result, most countries have realised the benefits of a politically independent central bank, charged with one primary objective. The most common objective of a central bank is a low and stable rate of inflation but it can also be, for example, the management of an exchange rate within narrow limits (this is the case with the Danish central bank that maintains the Danish Krone at a stable exchange rate against the Euro).
Monetary policy and Aggregate Demand
Remember that Aggregate Demand is made up of four different components: Consumer spending, Investments, Government Spending and Net Exports. Government spending is largely governed by fiscal policy, and the effects on Net Exports following changes in the interest rate will be dealt with in relation to International Economics. This leaves consumer spending andinvestments, and the size of the two components is very much determined by the interest rate.
When the interest rate rises the cost of borrowing money increases. This means that consumer spending, especially on durables, falls. The same is true for investments, i.e. the spending on capital by firms. Indeed, remember from microeconomics that “interest” is in fact the payment for the capital factor of production, and it is therefore very natural that the demand for capital falls when the interest rate rises. At the same time, the opportunity cost of spending as opposed to depositing money with the bank also increases, and this is another contributory factor in reducing AD.
When the central bank raises the interest rate, economists say that it uses contractionary monetary policy. This is because it contracts aggregate demand, that is, it makes AD smaller. The central bank wants to do so if the economy is experiencing demand-pull inflation– In such a situation, there is upward pressure on the level of prices because the total demand for goods and services is too high. Such a situation is also known as overheating.
On the other hand, when the interest rate falls this has a positive effect on aggregate demand. This is because the cost of borrowing decreases, and this, in turn, encourages both private consumption and investments. In fact, one might say that the price of gaining access to money has decreased. At the same time, the opportunity cost of spending has decreased since consumers and firms now get less interest when depositing their money with banks. Consequently, a fall in the interest rate has a double effect both in encouraging borrowing and discouraging savings.
When the central bank lowers the interest rate economists say that it uses expansionary policy since the consequence is an increase or expansion of aggregate demand. This is a policy that the central bank will seek to pursue if the economy is in a recession since the increased consumption and investments will boost the economy. Remember however the controversy regarding policies to shift AD curve to the right. Neo-classicals argue that such a strategy carries with it a great risk of inflation.
As mentioned above, the most common task that central banks are charged with is the task of maintaining a low and stable rate of inflation. The benefits of doing so are outlined in full in the article on inflation as a macroeconomic objective. The reason why a low and stable rate of inflation alone is a primary target rather than also maintaining a low level of unemployment is that there will be many instances when the two are in conflict. It may well be that the central bank can further reduce the level of unemployment by lowering the interest rate, but that this comes at the cost of higher inflation. Because the central bank is politically independent, it cannot, and should not try to evaluate which of the two objectives is most important. Instead, if it bears the sole task of managing the inflation rate, such evaluations will never be necessary. The government can thereby predict what the central bank will do in any given situation, and it can adjust its fiscal policy accordingly.
The value of monetary policy
Monetary policy and the ability of the central bank to rapidly adjust the interest rate to respond to changes in the economic climate are extremely valuable in managing the rate of inflation. Because the central bank has no conflicting objectives it is able to fully focus on its task without having to weigh advantages and disadvantages. This is not to say that the management of the interest rate is without controversy. The board of representatives that bears the final decision as to whether the interest rate should increase, decrease or remain stable often have different opinions because of their different takes on where the economy is heading in the future. The fact that this is hard to predict does bring an element of arbitrariness into the setting of the interest rate.
In addition, when the economy is in deep recession, it may well be that lowering the interest rate has a very limited effect. While this should certainly encourage both investments and consumer spending, people who are afraid to lose their jobs and firms who think that there are hard times ahead will nevertheless be reluctant to indulge in spending. In such situations, an increase in government spending might very well be more valuable than a lower interest rate (remember the rap-video featuring Keynes and Hayek and their respective explanations for the boom and bust cycle).
Finally, it must also be remembered that management of the interest rate still suffers from human errors. We are unable to predict exactly what is going to happen in the future, and, as a result, the interest rate cannot with certainty be set to the appropriate level. The result, if predictions turn out to be wrong, is either too high inflation or too strict a monetary policy, resulting in a slowdown of the economy.
Impact of interest rates
After the World Trade Center attacks on September 11 2001, the American economy took a very serious turn. Stock markets fell sharply for the second time within 18 months as the Dot-com bubble had burst just a year before. Alan Greenspan, the chairman of the Federal Reserve, the American central bank, saw the need to use expansionary policy to try and save the economy from a recession. As a result, interest rates fell sharply and the economy was saved for the time being. The low interest rate set by the Federal Reserve accompanied with loose regulations as to the amount of cash that commercial banks had to keep in reserve acted as irresistible temptations to increasing the amount of loans to private consumers. In fact, the banks went so far as to lend money also to people who were less likely to be able to pay back, so called sub-prime mortgages. The risks of such loans are obviously substantial, but so are the potential gains.
As it turns out, many people were, in fact, unable to repay their loans, and so they had to sell their homes. As the supply of houses increased on the market, the prices fell and, as a consequence, the value of the properties that people had mortgaged as security to their loans was insufficient to cover the value of the borrowed money. All of a sudden, the banks seemed likely to make huge losses, and so, investors abandoned them. This resulted in the 2008 sub-prime mortgage crisis and the consequent economic recession of a magnitude not seen since the 1930s. And low interest rates are, at least partly, to blame.
What you should know
- Monetary policy is policy concerned with the supply of money, primarily governed by the interest rate.
- Expansionary monetary policy is when the interest rate decreases. This encourages borrowing and discourages savings and thus has a positive effect on aggregate demand.
- Contractionary monetary policy is when the interest rate increases. This discourages borrowing and encourages savings and thus has a negative effect on aggregate demand.
- The central bank is politically independent and often charged with the sole task of maintaining a low and stable rate of inflation. It does so by managing the interest rate.
- Management of the interest rate is often difficult due to the inherent problems associated with predicting the future. In addition, the interest rate in itself may be insufficient to govern the behaviour of consumers and firms.