Monetary policy measures: changes in interest rate

Government and the macroeconomy – Monetary policy

Monetary policy measures: changes in interest rate

📈 Interest rate is the price of borrowing money. Think of it like the cost of renting a bike: the higher the price, the fewer people will rent it. Similarly, a higher interest rate makes borrowing more expensive, so people and businesses borrow less.

How central banks change interest rates

• Open Market Operations: buying or selling government bonds to add or drain money from banks.
• Discount Rate: the rate at which banks can borrow directly from the central bank.
• Reserve Requirement: the amount of money banks must keep on hand, not loan out.

Effects of raising or lowering the interest rate

Raising the rate (Δi > 0) ➜

• Borrowing costs rise → less investment and consumption.
• Demand for goods falls → inflation may drop.
• Domestic currency strengthens → exports become more expensive.

Lowering the rate (Δi < 0) ➜

• Borrowing cheaper → more spending and investment.
• Demand rises → inflation can increase.
• Domestic currency weakens → exports become cheaper.

Example: The Bank of England’s policy rate

In 2023, the Bank of England raised its base rate from 0.5% to 1.25% to tackle inflation. This move made mortgages and business loans more expensive, slowing spending and helping bring inflation back toward the 2% target. 📉

Exam tip: Answering questions on interest rate changes

1️⃣ Identify the policy action: Did the central bank raise or lower the rate? Use $Δi$ to denote the change.
2️⃣ Explain the short‑term effects: How does it affect borrowing, spending, inflation, and the exchange rate?
3️⃣ Link to the economy’s goal: Does the change help achieve price stability, full employment, or growth?
4️⃣ Use an example: Cite a real central bank action (e.g., BoE, Fed, ECB) to illustrate your points.
5️⃣ Conclude: Summarise whether the policy is likely to be effective in the given context.

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