Monetary policy

You will have to review your AS notes, 2.10 Monetary Policy before starting this unit.  You will also be tested on this knowledge in the Unit 4 exam.

Many of the topics covered there are essential knowledge at A2.


Monetary policy can involve controlling interest rates, the money supply and exchange rates.



Economists define money as being the set of assets in an economy that are used to buy goods and services.  Prior to the widespread use of money barter was used as a medium of exchange in which goods or services were directly exchanged for other goods and services.  Barter has replaced money in recent times of hyperinflation.


The liquidity of money relates to how easily an asset can be transferred into money; money is the most liquid of all assets (because it is already money!), shares are quite liquid as they are relatively easy to sell and an expensive car would not be very liquid as it would take more time and effort to convert it into cash.


Functions of Money

There are four functions that money performs in an economy:

  • A medium of exchange.  Money is accepted in exchange for goods and services.  Without it we would have to resort to bartering, for this to work there would have to be a double coincidence of wants.
  • A unit of account.  Money enables us to compare the value of a good or service with another one.
  • A store of value.  It is possible to hold on to money over time and exchange it for goods and services in the future.  This would not be possible to do with all goods in a barter economy.
  • A standard of deferred payment.  Firms will often accept goods or services to be sold on credit.  This means they accept that money will have value in the future.


The demand for money

We highlight four main factors that determine our demand for money:

  • Keynes’ Liquidity Preference – Keynes highlighted three motives for demanding money:
    • Transactions demand – the money needed for buying goods and services.
    • Precautionary balances – this is the money people keep just in case of unexpected purchases.
    • Speculative balances – when other assets are expected to fall in value, people will hold money instead.
  • The demand for money and the rate of interest – as interest rates rise the demand for money will fall.

Explain this relationship between interest rates and the demand for money.




Draw a demand curve for money on the diagram below that shows the relationship between interest rates and the quantity of money demanded.


  • Money demand and increases in real GDP – rising real incomes will lead to an increase for the demand for money.

Demonstrate this on the diagram below


  • Financial innovation – the demand for money has decreased in recent years as more people are using debit and credit cards to pay for purchases.

Demonstrate this on the diagram below



The Bank of England and the Monetary Policy

The Bank of England has three main policy instruments that it can use to affect the money supply in the UK:

  • Open market operations.
  • The repo rate.
  • Reserve requirements.


Open market operations

If the central bank wants to increase the money supply it is able create money and buy bonds from the financial sector.  This places extra currency in the hands of banks in return for a non-monetary asset.  If the bank wanted to reduce the money supply the central bank would sell bonds it owned to the banks and take the currency out of circulation.


The quantitative easing introduced by the Bank of England in March 2009 aimed to increase the money supply by £75billion.  Most of the extra money would be introduced into the markets through open market operations.


The repo rate

The repo rate is the rate that the Bank of England is willing to make short term loans to the banks.  Each night banks will either have a requirement for or an excess of money; they are willing to lend to money to each other.  The London Interbank Offered Rate, known as LIBOR, is a daily rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market.


If there is a general shortage of liquidity in the money markets the Bank of England will be willing to lend money to commercial banks and accept an asset as collateral on the loan.  There will be an agreement to repay the loan on a specific date; the repurchase, or repo, rate is the difference between the price the asset is sold to the central bank and the price it agrees to sell it back expressed as an annual percentage rate.


The base rate set by the Monetary Policy Committee is also known as the repo rate as it is the interest rate it is willing to lend to commercial banks.


If the repo rate increases, commercial banks will respond by trying to reduce the amount they have to borrow and they will pass their increased costs of borrowing onto its customers.

What will commercial banks do to their interest rates when there is a rise in the Bank of England’s repo rate?





Reserve requirements

Reserve requirements, sometimes known as the reserve ratio, are regulations about how much money banks must hold in reserves in ratio to the deposits made by customers.  These reserves enable the banks to satisfy the cash withdrawal needs of its customers.


Increasing the reserve requirement will reduce the funds the bank has available for lending and will therefore reduce the money supply.  The Bank of England no longer has a reserve requirement.  In 1998 the reserve ratio in the UK was 3.1% compared to 10.3 and 11.9% in the USA and Germany respectively.

What might be an implication of the UK have a much lower reserve ratio than other countries?





Factors Considered by the MPC

The nine members of the MPC consider a wide range of economic data that is collected by the bank and its regional agents.  The main areas of the economy it looks at can be found in the monthly minutes and quarterly inflation report that the bank releases onto its website, they are as follows:

  • Financial markets
  • The international economy
  • Money and credit
  • Demand and output
  • Costs and prices
  • The labour market

Outline the key pieces of information for each heading that you would analyse were you a member of the MPC.

Financial markets

The international economy

Money and credit

Demand and output

Costs and prices

The labour market



Exchange Rate Policy

A strong pound will lead to cheap imports and this will reduce cost push inflationary pressures as the price of imported goods, components and raw materials fall.

Outline how an increase in the Bank of England’s rate of interest will lead to the pound becoming stronger.

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