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Monetary policy
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Monetary policy uses interest rates to influence spending in the economy. It is usually run by the central bank.
What monetary policy is
Monetary policy: changing interest rates (and the money supply) to influence the economy.
An interest rate is the cost of borrowing money and the reward for saving.
In many countries the central bank sets the main interest rate, such as the Bank of England in the UK.
An interest rate is the cost of borrowing money and the reward for saving.
In many countries the central bank sets the main interest rate, such as the Bank of England in the UK.
How interest rate changes work
Higher interest rates:
Consumers: borrowing and mortgages cost more, saving is more rewarding, so spending falls.
Businesses: loans cost more, so investment falls.
Result: lower inflation, but slower growth and possibly higher unemployment. The currency may also rise in value.
Lower interest rates have the opposite effects.
Consumers: borrowing and mortgages cost more, saving is more rewarding, so spending falls.
Businesses: loans cost more, so investment falls.
Result: lower inflation, but slower growth and possibly higher unemployment. The currency may also rise in value.
Lower interest rates have the opposite effects.
Asset purchases
Central banks can also buy assets such as government bonds (often called quantitative easing). This puts more money into the financial system and helps keep interest rates low, to encourage spending when the economy is weak.
Inflation is well above target. What would the central bank do and why?
- Higher rates make borrowing dearer and saving more attractive.
- Spending falls, reducing demand-pull inflation.
Answer: Raise interest rates to reduce spending and inflation.
Monetary policy changes interest rates, set by the central bank. Higher rates cut borrowing, spending and investment, lowering inflation but slowing growth. Asset purchases inject money to support spending.
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